Posts tagged ‘investor sentiment’

Banking On It

With equity markets reaching ever dizzier heights this year, oil stable and government bonds serene it is difficult to think back to how the financial world felt about a year ago. Back then, an eye-watering collapse in risk pricing apparently presaged a rerun of the Great Recession. The clear catalyst was to be a systemic financial crisis just like that of 2007-9, though this time originating in a China riddled with insurmountable debt problems. Bank worries persisted into the summer, with the European Banking Authority’s July “stress test” widely expected to demonstrate the insolvency of many weak banks (and especially those in Italy).

These fears – intense as they had been – eventually dissipated. Since its post-referendum nadir the UK’s FTSE All Share Banks Index has risen by 51%, comfortably outpacing the broad market ex banks by more than 30%. Yet the G7 Finance Meeting summit on in Italy right now has continued to generate headlines about bank solvency in that country. So has the problem gone away? And should risk assets head south once more, would it be a financial collapse that Mr Market, once again, was banking on?

The numbers in Italy are indeed problematic – for Italy. But they are too manageable and too well-known to foment a systemic crisis more widely. To answer the question more broadly, however – which in times of panic is invariably how it is phrased – we can take a look at various data on bank solvency and non-performing loans across the world to see where it stands today, where it stood during the crisis years and what happened to it in the supposed nightmare period of 2016.

Let’s start with non-performing loans. This is the most obvious cause for concern in the banking system: when a bank lends money to a sufficiently large number of customers who default on their loans its income falls, its balance sheet weakens and it can in extremis go under.

In the UK, the combined value of reserves for loan losses at Barclays, Lloyds and RBS (including all their current subsidiaries) peaked at £51.4bn in 2011. By the end of 2015 this had fallen to £15.0bn, and it fell further last year to £11.4bn, which is below the pre-crisis levels of 2007. In the US, where the subprime debacle saw the most severe financial bloodletting anywhere, the figures for the Big Four (Bank of America, Citi, JP Morgan and Wells Fargo) have charted a similar trajectory. The peak was reached earlier, in 2010, at $158.8bn, had fallen to $49.9bn by 2015’s close and ended last year at $48.5bn.

Taking a more global view, the IMF collects data by country on actual non-performing loans after the event, and this naturally tells the same story as individual banks’ bad debt provisions. Starting again with the UK, the banking system in aggregate saw the proportion of non-performing loans to total gross lending peak at 4.0% in 2011, falling to 1.0% in 2015 (data for last year is not available yet). The US hit a more severe peak of 5.0% in 2009, which had run down to 1.5% by 2015. It also posted that level last year.

Turning to the market’s bogey men in this department: Euro area banks didn’t see their aggregate loss ratio peak until 2013 on the back of the double-dip recession there (at 7.9%). But this has since fallen, reaching 5.8% in 2015 and continuing to fall to 5.4% over last year. And in China, while the same ratio did actually increase in 2016 this was only by 0.07% (the figure was a stable 1.7% from 2015-16 at only one decimal place). Note, too, that the Chinese peak was all the way up at 29.8% back in 2001, which ought to put this squarely into context.

As well as the incidence of loan defaults, the resilience of balance sheets is another key moving part when it comes to assessing the vulnerability of a banking system. So we can also look at bank capital ratios to see just how much sleep we might expect to lose should those not-very-concerning loan loss numbers begin to tick up again.

Regulators tend to focus on “tier 1 capital”, which can be summarized as balance sheet equity plus whatever debt can be written down without putting a bank into distress. The EBA helpfully compiles data on this for the EU in aggregate. Before the financial crisis, the tier 1 capital ratio for EU banks was 8.0% (2006). With the assistance of vast sums in emergency state support and generous debt swaps this percentage actually rose slightly during the crisis itself before really taking off in subsequent years to hit 14.9% by the end of 2015 and 15.7% last year. In other words, just as loan losses have been falling, capital buffers have been increasing – to almost twice the strength they had a decade ago.

Turning to the IMF once again we can have a look at similar data for (balance sheet equity) capital ratios across the world. This rather more traditional measure of capital is narrower than tier 1 and so the numbers are smaller and not quite so illustrative. They do, however, tell a similar story: the euro area’s “pure” bank capital ratio increased from 8.0% to 8.5% in 2016, ahead both of its 2011 nadir (5.6%) and pre-crisis level of 6.6% (2006). The Chinese ratio has risen from 5% to 8% over the last ten years, in the US it grew slightly from 10.5% to 11.7% over the same period and here in the UK the increase was from 6.1% to 6.8%.

There have been some weaknesses visible in this data – in Russia, for example, and in Brazil, which both suffered so badly at the hands of weak commodity prices in recent years. Again, though, banking issues in these countries have neither the scale nor the surprise factor to cause a genuine, systemic upset elsewhere. And in most other places, including those over which the strongest concern has traditionally been expressed, we can see that banks, as a whole, are in rather better shape now than they were in 2015 – never mind during the subprime crisis and Great Recession.

“In times of crisis”, this blog wrote back in February last year, “it behoves us to seek refuge in facts.”  The view that last year’s funk was nonsense proved correct, and provided an opportunity. But it is not just when the market is in crisis that we need to mind our fundamentals. Greed is every bit as dangerous as fear. We might not have to fear for the banking system at present (especially in places where interest rates go up) – but just because Mr Market looks unlikely to stub his toe on the banking system in the near future that doesn’t make him immune to stumbling elsewhere.


12/05/2017 at 3:01 pm

Concerning Growth

The bells of doom continue to toll, with headlines appearing in recent days about the forthcoming global recession (e.g. yesterday’s news wires, business TV channels, the financial press, etc.) Now it is true that the MSCI World Index of developed-market stocks has just suffered its biggest monthly fall since all the way back in the distant past of August 2015. But does this really augur a global recession, similar to the Great Recession of 2008-9?

In times of crisis this blog believes that it behoves us to seek refuge in facts.

Let’s start with Europe. Yesterday’s EU Commission forecast carried a lower estimate of economic growth for the eurozone this year than it did at the time of the autumn forecast last November, it’s true, and this has been taken in some quarters as support for the bear case. But the revision is negligible: down from +1.8% to +1.7%. It still represents an increase on 2015, not a diminution. And in absolute terms these kinds of numbers are breakneck for the poor old euro area, where growth has averaged a meagre +1.3% real over the whole period of the single currency’s existence and a paltry +0.7% over the last ten years, marred as they were by the double dip recession. Logic, too, is not on the side of the bears here: Europe as a whole is the single biggest importer of crude oil by some distance. So while Norway and Scotland are not enjoying crude prices of $30 per barrel, last year’s figures for the eurozone economy bear out the massive positive effect they have had on the continent more broadly. The forecast numbers for this year do the same.

Crossing the Atlantic, the picture in the US and Canada is more mixed. With its oil economy hit hard Canada’s GDP growth has fallen away to zero in recent months, and is predicted to come in at 1.2% for 2015 overall – less than half the growth rate of the previous year. Last week’s US print for Q4, up only 0.7% on an annualized basis, was weak but roughly as expected: markets had been bracing themselves for the effects of the strong dollar on growth. Though even then it is worth noting that the greenback has plunged somewhat over recent days amid all the disappointment. And for the current calendar year the consensus is for growth of 2.4% – a little below trend, perhaps, but not, in any way, shape, or form, a recession.

Another ocean away, Japan only just emerged from a real life recession back in 2014. The consensus GDP forecast for 2016 is +1.0%, and with consumer and business confidence strengthening into the end of last year there is no sign that this represents unreasonable optimism. With the long run in mind one might observe that growth of 1% per year is not desperately exciting, that this is connected to the country’s demography and that there are lessons for many other economies on this front soon similarly to be learned – but that is another, much larger, story.

Hopping across the seas around China and her neighbours – minding our step over those disputed archipelagoes on the way – emerging Asia is not very convincing as a recessionary prospect either. Only this week the Chinese government published a revised growth target of 6.5-7%: this is below the double-digit rates of expansion to which we became accustomed prior to the Great Recession but not exactly sluggish, and quite some distance from an economic contraction. South Korean growth is forecast to tail off a bit this year, true – all the way down to +2.9% from +3.0% last year. Growth in Malaysia too is expected to come off the boil, reaching a mere +4.5% this year. Still it is not all bad news for the Asian economies: growth rates are actually expected to increase this year in India, Indonesia, the Philippines, Thailand and Taiwan.

Lest we allow ourselves to be lulled into a false sense of security, there are countries where growth prospects remain quite bleak. Mineral economies for instance, such as those of Brazil, Russia and Venezuela, are forecast to contract again this year, albeit at less alarming rates than in 2015. These are the areas where cheap oil tends to be a net economic negative. Elsewhere, however – for most of the world – it is a net positive. (The figures on this subject are readily available if any “oilmageddon” bears reading this piece care to look at them.)

Finally, the idea that we are going to be driven into a recession by the stock market’s late gurgitations is the height of self-regarding ludicrousness. Just think: back in the 1990s, NASDAQ were putting adverts on in the middle of News At Ten, Cisco Systems was worth about as much as Belgium and day trading was the easy route to fulfilling the American dream. Then everything collapsed in 2000. And the effect on the US economy? Real GDP growth in the fourth quarter of 2001 fell to +0.2% on the year. That is as bad as things got. There was never any recession.

Equally it is almost impossible to make a reasoned, cold case for a global recession this year. Predictions to the contrary are not without their use though. They tell us something about sentiment, and suggest – perhaps quite strongly so – that the current dislocation might present the more level-headed investor with a buying opportunity or two.

05/02/2016 at 4:42 pm

Crash! Panic! Doom!

So this week London entered a bear market. Some commentators discern echoes of the “2008 financial crash”. Sage market participants – who have been warning us about China* / Emerging Markets* / the Euro* / QE* / Commodities* / Debt* / Deflation* / Monetary Tightening* [*delete as appropriate] – for several years have finally been proved right. Several of them caution, sagely, that we should remain cautious as it could have further to go.

Yes, this week, the FTSE 100 Index entered a “bear market”, as defined by a fall in value from its closing peak (7,103.98 on 27 April 2015) of at least 20% – 20.14%, to be precise, reached on Wednesday with a closing price of 5,673.58. It should be obvious that this signifies nothing whatsoever more than a fall of 18% or 19% but there we are. Markets have their conventions. This is now, technically, a “crash” rather than a “correction” (a fall of between ten and twenty percent). And some would have us believe it’s 1929 all over again.

Such, however, it cannot be. Global equity (as measured by the MSCI World Index) has not entered a bear market – it has fallen by 17.62% from its peak – and this is entirely due to Wall Street. The S&P 500 has shed a mere 12.74% from its heady peak last May. Since the US market makes up a little under 60% of the developed world’s total market cap this more than makes up for the fact that Tokyo and … erm … Brussels? … have entered bear markets alongside London with the TOPIX and Euro Stoxx 50 indices down 23% and 25% respectively.

Even here in the UK the crash is not that clear cut. The mid cap FTSE 250 Index has shed only 14%, with the small cap index having done slightly better. Considering the fundamentals this is understandable. There are few oil supermajors bestriding this particular corner of the marketplace, or mineral colossi. The much vaunted overseas exposure of the large cap index has been, at best, an equivocal strength with the UK economy doing as well as it has (not to mention the distorting effects of all that foreign exchange exposure). So the current infestation of bears has been locally as well as globally selective.

Still, who needs “fundamentals” with all that lovely panic to go around! Surely it can only be a matter of time before those other columns tumble? After all, it’s 2008 all over again!

Except, of course – it isn’t. Not even remotely so. Back in 2007, to refresh our memories, there was a massive over-extension of credit via packaged structures that were as poorly valued and understood as they were widely held. A few mortgage arrears in the US later and the world’s financial system suffered cumulative capital losses just shy of $2trn and would have collapsed without the $1.5trn of capital that then had to be pumped into it, mostly by governments. Then in the autumn of 2011 it looked as though the bond market might close to Italy. Since the Italian economy is rather large, with a commensurate burden of sovereign debt, it was certain that neither the IMF nor its sponsoring governments would have been able to afford a bailout. At that point we could have seen governments across the developed world plunged into default.

Now that would have been a disaster.

And what is behind the doomsaying today? The rate of GDP growth in China down by 0.1%! Oil falling – which is admittedly more dramatic – but unlike the financial crisis will prove an economic benefit on average (and perhaps delay the need for monetary tightening in Britain and elsewhere). Or perhaps it is simply the case that the bull market run since 2009 got ahead of itself and equities are anticipating the forthcoming change of cycle.

On that last point there is something further to be said about all those crashes and corrections. Amid the justifiable fear of 2011 the S&P 500 had a peak-to-trough fall of 19.4%. Admittedly, this is a whole 0.6% short of a full-blown bear market, or “official” crash. But it was not much fun for investors at the time. And away from the US, stock markets have had a much more equivocal rally. While the S&P raced ahead during 2013 and 2014 for instance, returning 50% over those two years, the FTSE 100 returned only 20%. In Japan, suffering from the earthquake and tsunami of 2011 and their aftermath, the market did not even start to climb until the tail end of 2012. The years since the credit crunch and Great Recession have seen healthy equity market returns – at times, in some places, and in fits and starts. But it has not been any sort of eye-watering, valuation-busting rocket trip.

We are where we are. But the crash has been as partial as the bull run, the panic is hard to justify – in some respects, even, absurd – and it may yet prove that all the doomsaying is being listened to just a little too closely.

22/01/2016 at 6:26 pm

Confidence Trick

In these uncertain times, let us refresh ourselves by beginning with what was again proved this week to be an indisputable fact: Mario Draghi is the most significant and successful central banker in the world.

The announcement three years ago that the ECB was assuming the power to intervene in bond markets, when he was not even 12 months into the job, put the sovereign debt crisis to bed, restored market confidence across the world and helped turn the creaking hull of the eurozone supertanker away from recession. Two years later his €400bn bank liquidity programme and adoption of a negative policy rate had analysts calling him a rock star. Another €700bn splurge and surprise rate cut followed. And at the beginning of this year Mr Draghi announced a €1.1trn programme of quantitative easing.

So yesterday’s announcement that the ECB was ready to modify the “size, composition and duration” of its QE exercise was part of a pattern. Draghi and team are being seen to do whatever it takes to re-normalise the eurozone economy. Indeed, as he put it at a speech he gave in London on 26 July 2012:

The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Everybody believes you now, Mr Draghi.

Market reaction yesterday and overnight was, in a word, electric. The euro plunged by 1% against the dollar in the space of half an hour to close the day 2% weaker overall. (That is a more significant one day fall than the planned devaluation of the Chinese yuan that caused such consternation back in August.) The Euro Stoxx 50, which had been trading flat throughout the morning, rocketed up in the afternoon to post a +2.5% close. European bond yields hit new record lows: the 2-year bund was pricing at -0.35% in the opening hours of this morning while the 2-year Italian buono hit negative yield territory for the first time.

There is a good, detailed overview of the global impact of Mr Draghi’s latest star performance from Reuters here: Global Stocks Hit Two-Month High On Dovish Dragi Message. But it is the quotes from market observers which we will focus on before leaving this subject:

“Investors and traders are buying the idea of expected action out of the Bank of Japan and the ECB,” said Ben Le Brun, market analyst at trading platform provider optionsXpress.

The Chinese central bank’s injection of 105.5 billion yuan into 11 banks via its medium-term lending facility this week, combined with possible additional stimulus from the ECB, “may give the Fed more reason to raise rates by year end,” said Chris Brankin, chief executive officer of online trading platform TR Ameritrade Asia in Singapore.

“Draghi has come out and kitchen-sinked the whole thing, everything is now on the table,” said Gavin Friend, a strategist at National Australia Bank in London. “You combine what the ECB is now saying with (the fact) that the Fed is not going to be going aggressively and that the Bank of Japan is going to want to get involved, then you say ‘Blimey!'”

Mr Draghi has played his role exceptionally well, but the dominance of central bank rhetoric and activity over market behaviour is unhealthy. When the People’s Bank of China devalued over the summer for example it was treated as a disaster – a desperate act to prop up a seriously weak economy. The falling stock market in China had helped unsettle the world and the markets’ interpretation of events took place against a background of gloom. This week, however – thanks to the ECB – we inhabit an era of sunshine and optimism. So when the PBOC announced further monetary loosening today it was seen not as desperate but as a sign of “the government’s determination” which has now lit “a fire under global stocks” as “US equity futures jump”, to quote some of this afternoon’s commentary. Markets hated Chinese policy over the summer and loosening by the PBOC was taken badly; today it’s just what was needed to cement the rally in place.

If there is a cloud to go with this week’s silver lining, therefore, it is the now familiar truth that reliance on central banks has become a major source of volatility. “Money Markets Primed for Draghi as Bets Jump on Deposit-Rate Cut”, says Bloomberg’s headline today. And what if there is no cut on 3 December? Or if there is, but this is seen as bowing to market pressure – the kind of pressure which appears now to govern decision-making at the Fed? One day markets are given a boost by “Super Mario”, the next, they start looking for more – and pricing it in.

Volatility is the textbook definition of financial market risk. Mario Draghi is, to say the least, an impressive figure. He has given investors much to be very grateful for. But he and his confreres around the world, counter-intuitive though it might seem, have actually helped to make investing today a riskier proposition. To put it another way, we have become used to looking to central banks to underpin market stability; and by relying on them to the extent that we now do, ensured the exact opposite.

23/10/2015 at 3:42 pm

Kicking The Can

The big news this week, of course, was the Fed. Rarely has inaction been so exciting! The statement put out by its Board of Governors is quite pithy as these things go and worth a read in full, and the salient policy points are all sandwiched within a single paragraph as follows:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account … labor market conditions … inflation pressures and … expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.

US unemployment for August was 5.1%, down half a point from the beginning of the year and nearer the bottom than the top of the Fed’s own range for the “longer-run normal rate of unemployment” of 4.7-5.8%. There is nothing here to justify emergency monetary conditions whatsoever. Despite the statement, therefore, the US labour market was in practice irrelevant to the decision taken by its central bank.

On inflation, the Fed notes elsewhere the “transitory effects of declines in energy and import prices”, and is absolutely right to do so. Fortunately it also has access, just like the rest of us, to “core” measures of both consumer and producer price inflation which specifically exclude food and energy. Headline CPI has crashed down from 2.1% in the spring of last year to 0.2% today, but the core measure has risen this year from 1.6% to 1.8%, not meaningfully distant from the stated target of 2%. Again, this is not consistent with an emergency monetary stance.

Having abandoned at least one and a half of the two elements of its mandate, then, the Fed has effectively announced it is acting with reference primarily or solely to an unofficial third: “financial and international developments”.

In one sense this is a masterstroke. Attributing loose policy to sources other than the domestic economy eliminates the risk of a bearish response to a downbeat assessment of the situation at home. (The Fed has come a cropper here before.) When a central bank produces an economic assessment that is news. When it points to events offshore that everyone has already seen, it says nothing new.

From another angle, however, yesterday’s decision does not look quite so masterly. Invoking the stock market as a reason for cheap money used to be known as the Greenspan Put, a source of moral hazard under the eponymous Fed chairman which attracted some of the blame for the financial crisis. And at least efforts were made to justify Mr Greenspan’s option writing in terms of a “wealth effect” on US household spending. Extending the put to the stock market in China seems startlingly multilateral even for these enlightened times.

Furthermore, all the Fed has done is postpone a move which would have taken nobody by surprise if they had done it this week. It is still perhaps a little early to gauge the market reaction but stocks are down in both the US and Europe today. The dollar has weakened just a touch against the euro, is pretty much unchanged against sterling and the yen and the Chinese yuan has not budged, so there is as yet no consoling impact for American exporters and multinationals. All that is certain is that the postponement has prolonged a key source of uncertainty.

The impact of a 25bp rate hike would have had a negligible impact on everything apart from sentiment. And it is far from clear that its market impact would have been any worse than that of the Fed’s eventual, barely defensible decision to dither.

So much for the new mandate to shore up financial and international developments.

Kudos, in conclusion, to Jeff Lacker, President of the Federal Reserve Bank of Richmond, the only one of the Fed’s twelve decision-makers to vote for a hike yesterday. His colleagues have in reality opted for nothing more cogent than mañana.

18/09/2015 at 3:43 pm

Sins Of The Policymakers

This morning’s leading headline on Bloomberg News read as follows: “Stocks Advance in Europe, Asia Amid China Holiday … ”

Without the peril of the Chinese stock market to contend with, European bourses were up by 1-2% early in the day and are higher at the time of writing. This certainly fits the narrative of those who see the collapse of the supposed equity bubble in China as the source of all the summer’s ills.

(Before moving on, a brief comment on that “supposed”. The Shanghai Composite Index rose by 58% from the start of this year to its peak on 12 June, having risen by 53% in 2014. It hit a p/e of 23.5x in the process – then began to fall. By the bottom on 26 August the drop had reached 43%. If that isn’t a bubble … ?

On the other hand that p/e was well below the 45.5x reached at the market peak of 2007 – a peak which has yet to be exceeded. And it is miles short of the 60-70x levels seen during the twilight of the go-go 1990s tech boom, and below the average level so far this century. In addition, +53% is only the fourth-highest calendar year price return for the index in the last ten years, the highest having been seen in 2006 when the market much more than doubled. Finally, the market was valued at under 10x earnings for long stretches of 2013-14 before the rally began, well below the 14x and 12x reached at the market bottoms in 2005 and 2008.

This is a febrile market which has undergone rapid change but to interpret its rally from the depressed point of mid-2014 as an egregious bubble episode is to make a glaring analytical mistake.)

Some of the actions of the Chinese government have been woefully unhelpful. Direct interventions in the stock market have exacerbated falls and sharpened investor concerns, as tends to be the way of these things. At the same time, special interests in the corporate sector have sought to manipulate the government’s response to their advantage.

Other parts of the world were in exactly the same place very recently. The SEC banned short selling of financial stocks on Wall Street from Friday 19 September 2008 – the week of the Lehmans bankruptcy – in an effort to “protect the integrity and quality of the securities market and strengthen investor confidence.” By the time the ban ended after the close on Wednesday 8 October the S&P 500 Diversified Banks index had fallen by another 22%. Christopher Cox, then Chairman of the SEC, gave an interview to Reuters after Christmas that year which contained the following little nugget:

Cox said the chief executive of one major U.S. investment bank even urged suspension of normal trading rules across the entire U.S. market, likening the situation to how Abraham Lincoln suspended habeas corpus during the Civil War and Franklin Roosevelt sent Japanese-Americans to internment camps during World War Two.

The chief executive said, “that is how America made it through such crises, and we couldn’t be too focused on maintaining the rule of law,” Cox said.

Now that is panic. When it hits markets it is perhaps understandable that policymakers are not immune.

At the same time as the SEC was floundering around trying to put the clock back, however, the US Treasury began to implement measures under the newly-enacted Troubled Asset Relief Program, including the purchase of mortgage-backed securities to assist in the repair of bank balance sheets. On 8 October 2008 the Fed cut its target rate for the first time since April of that year from 2% to 1.5% in a concerted move with the ECB, Bank of England and the central banks of Canada, Sweden and Switzerland. A month later it began its first tranche of bond purchases under QE.

The speed of the banking sector recovery in the US – as opposed to Europe or the UK – has been one of the great relative strengths of the American economy. While some actions of the American government were woefully unhelpful, therefore, others were more constructive.

Exactly the same is true of the situation in China today.

As this blog remarked over the summer, it had been ignored amid all the attention on stock markets that China’s exporters were being hobbled by the quite sudden strength of her currency against the euro (and, for that matter, the yen). Only a few days after that post was published the People’s Bank of China devalued the yuan by 1.9%, its most significant depreciation since the epoch-making 50% shift engineered in January 1994. By the end of the week the yuan was down all of 2.9% at 6.39 and has stayed close to that level ever since. A few days later the 12-month benchmark lending rate was cut, for the fourth time this year, and a further reduction in the required deposit reserve ratio announced for major banks. At this point the PBOC had fired all three monetary weapons in its arsenal in a single month.

Back in the 1990s China came to dominate production in certain low-technology sectors, such as toy manufacture, and remained a relatively small economy (still smaller than Italy by the end of the century). Through continued competitiveness, investment, innovation, and broadening into higher-tech areas such as computers and mobile phones, Chinese exports overtook those of the US in 2007 and of Germany two years later. Today China is the world’s largest exporter by a mile, with the annual pace running at $2.4trn versus $1.6trn for the US; fifteen years ago China exported about a quarter as much as the US did.

So exports matter to the Chinese economy, devaluation ought to help exporters, and monetary softening elsewhere ought to ease some of the pain in the property market and contribute to lending growth. All this is fundamentally supportive. Nonetheless, the devaluation in particular – arguably the least contentious policy response of all – was interpreted as a sign of panic and the stock market continued to fall. In other words the actual direction of monetary policy was ignored in favour of the presumed context for its loosening. This was obviously a bearish response which again has clear recent parallels elsewhere.

What must surely be only a little less obvious are the implications of this response for imminent policy action in other places. Mr Carney at the Bank of England has just dismissed the idea that the kerfuffle within and over China will throw the MPC off their envisaged tightening path for rates. In the US, speculation over the timing of the first hike in the fed funds target since June 2006 has reached fever pitch. Will it motor up to 0.5% in two weeks’ time, as the majority of forecasters currently expect? Or will there be a delay?

Most importantly for investors: would a September hike be taken as evidence of a strong recovery, or would it ignite fears that the Fed is taking away the punchbowl too soon? And would delaying until next month be seen as a welcome reprieve, or betray a conviction that the US economy’s expansion is weaker than was thought?

The consensus from market participants still seems to be that monetary tightening will be accompanied by the upward march of equity benchmarks because (a) tighter money is a sign of economic strength and (b) that’s what happened last time. But as the events of recent weeks have shown, markets can get nervous again very quickly. And the Chinese experience is a reminder that in those circumstances, even positive policy decisions are taken as a sign of something bad.

It is difficult – even, perhaps, irrational – to dislike stocks more today than before they tumbled. There does not appear to be a new recession suddenly lurking around the corner. But complacency over the ability of today’s stock markets to take higher rates in their stride sits uneasily with the reaction to China’s very modest devaluation and other policy manoeuvres.


03/09/2015 at 3:43 pm

Breaking Records

There was some cheerful news for the UK equity market this week as the FTSE 100 index closed at a record high of 6949, finally beating the previous high – 6930 – it had reached way back on 30 December 1999. This milestone has generated a lot of comment on topics such as its relevance as an economic indicator and whether it comes as a sign that investors should sell. So what, if anything, does the record-breaking date of Tuesday 24 February 2015 tell us about the value of the market?

It has taken more than fifteen years for the 1999 record to be beaten. That is a good long time in financial markets, and perhaps especially so for markets in growth assets which have historically offered long run real returns of 5% per year. Had December 1999 been a textbook average starting point for investing in the UK stock market, then, and dividends from the FTSE 100 precisely matched the rate of inflation over the period we might have expected to see a price return of 1.05^15, or 108%. That would put the index on a level of 14407 rather than 6949 today.

When assessing markets, of course, we should not look at price alone. December 1999 was very far indeed from an average starting point. The price / earnings ratio for the FTSE 100 peaked that very month at 30.5x, de-rated sharply over the next couple of years and continued to descend more gradually, but very steadily, to lows (for the time) of around 12.2x in the summers of 2006 and 2007. This of course reflected the absolute reversal in sentiment from euphoria to depression associated with the collapse in the TMT / internet stock market phenomenon of the 1990s. During the Great Recession and its aftermath the p/e had a few bouts below 10x and has now bounced back to 16.6x, slightly above its twenty-year average level and somewhat lower than the 19.1x midpoint of its low-high range over that period.

Of course what this means is that the valuation picture is much more supportive of this new record price level than it was back when we last saw it at the end of the boom-boom 90s. This is even more the case when we flip the p/e ratio on its head (1/16.6 giving the conveniently round percentage of 6.0%) and compare this resulting earnings yield to a ten-year gilt yield of 1.8% and cash savings rates mostly below that. Back in December 1999 the earnings yield on the FTSE 100 was 3.3% as against 5.5% on the ten-year gilt and, by coincidence, a Bank of England base rate of 5.5% as well.

So breaking the 1999 record is not an obvious sell signal, and tells us at least as much about market sentiment and overvaluation back then as it does about those things today. On the other hand, given how close the current valuation metric is to its long(ish) run average, we should perhaps be expecting a total return of 5% plus inflation should 2015 turn out to be an equilibrium year for the UK market – but wouldn’t you just know it, we’ve had 5.8% of that already for the year to date. Still, a few months’ stagnation now is a small price to pay should that 5% real rate of return compound us forward for the next fourteen years from 2016 onwards. Again making the frivolous but convenient assumption that dividends match inflation, that would put the FTSE 100 on a price of 13758 come the end of 2029.

Perhaps worrying about price points at specific dates is not as useful a decision-making exercise as some others, then, especially when those dates are so very far apart. With the market at its current level it is obvious that it could move in either direction from today until the end of the year. Where it stood in 1999 is really not relevant. Before abandoning the notion of record stock market levels entirely, however, let’s briefly compare the positions of the other major developed-world blue-chip benchmarks.

In the red-in-tooth-and-claw corner stands the S&P 500, which has been consistently making new record highs since early 2013. (Its latest was 2115 on Tuesday, way ahead of the previous cycle peak of 1565 seen in 2007 and the dotcom era high of 1527.) In the very much bluer corner is the Nikkei 225, which rocketed up through Japan’s 1980s economic miracle to a high of 38915 on 29 December 1989. Today it closed at 18797, and will need to grow another 107% before it can eclipse that level, which could clearly take some time. Also looking rather glum is the Euro Stoxx 50, marked at 3572 at the time of writing down from prior peaks of 4557 in mid-2007 and 5464 in March 2000. (As an aside at this point, some of the British commentary on the new record has pointed to Germany’s DAX as an example of an index which has long eclipsed its 2000 peak. Unfortunately, however, the DAX is a total return index, meaning that dividend payments are rolled up in its value, giving it an unfair advantage against plain old cap-weighted price indices like the Footsie. The MSCI Germany index, by contrast, has beaten its 2007 peak but remains below its all-time high of March 2000.)

Again, the various record levels reached by these markets can tell us a lot about the start as well as the end points. The pitch of excitement – and in other parts of the developed world, awe – over 1980s Japan is well captured by that long-ago market pinnacle that will not likely be scaled again for many years. But it is instructive also to look at those peaks and troughs which are common to all these (huge and important) equity markets: highs across the board at the turn of the century, then again in 2007, and on the other hand the sharp falls in Q3 2011 … At times like these markets move in concert because they are thinking in concert – sometimes justifiably, sometimes not. The divergence between their performance over the last couple of years tells us that this is not happening yet. Again, there is good reason why this should be so when we consider differences in earnings, valuation, economic and sentimental factors between the different indices, but it should probably give us comfort too that the new closing record for the FTSE 100 is not part of some global rapture as it was fifteen years ago.

Apart from anything else, it never does any harm when an event like this comes along to provoke thinking and discussion. So well done to the UK stock market for beating its record, and let us enjoy sifting through the analysis before attention moves on.

27/02/2015 at 4:00 pm

The Joy Of Negotiating

While they may not yet be making headlines across the broader media as in days gone by, the ongoing negotiations between Greece and her creditors are the subject of the most widely-read article on Bloomberg today. Entitled German-Led Bloc Willing To Let Greece Leave Euro, the piece has the following money quote from Edward Scicluna, finance minister of Malta:

Germany, the Netherlands and others will be hard and they will insist that Greece repays back the solidarity shown by the member states by respecting the conditions … They’ve now reached a point where they will tell Greece ‘if you really want to leave, leave.’

It is now nearly five years since the downgrade of Greek debt caused worldwide panic over the condition of Europe’s sovereign balance sheets, and for much of that time there have been some who have advocated euro withdrawal and default as the solution to the country’s problems. Somewhere near the zenith of this view’s popularity readers may remember that it was Titanically flawed:

First of all, the currency … There would be rapid depreciation – indeed, the possibility that [it] could cease to be transferable internationally. (The Icelandic krone threatened this at the nadir of the recent crisis with the result that the supply of imported food was jeopardized.) Even if the drachma were tradeable, immediate, rapid inflation would occur. At the same time, bank deposits and other assets would have to be re-denominated, decimating the wealth of the nation overnight. These twin effects would demolish household and business consumption and consign the country to a further period of sharp economic contraction.

All well and good, say the defaultists. But at least Greece would be free of her debt!

Yes, and no. Greece is still running a budget deficit and in the catastrophe scenario this would get worse. So unless the Greeks wanted total state shutdown, they would still have to borrow money. Who would be the lenders? The EU; the IMF: exactly the same people who are lending to them at the moment. The conditions imposed by those lenders – who would still have effective control of the country’s economy until their loans were repaid – would be at least as punitive as the conditions they’re imposing now. In other words, there would be at least as much austerity to contend with, and possibly more.

One key feature of the economic landscape has changed since then, however: Greece has been running a primary budget surplus since the middle of 2013. This means that, ignoring debt interest, the government is raising more in tax than it spends. The last available data from the Bank of Greece (for November) has this primary surplus running at 2% of GDP. There are suspicions that the position has deteriorated since, but the key point is that – in theory – the Greek government could walk away from its debt and let its creditors go hang as it would no longer need to borrow money.

Bearing in mind the point about the currency, banking system and the rest, this surplus would likely not last very long in the event of a “Grexit”, so it isn’t that strong a negotiating point. It does, however, make such a decision appear less obviously stupid. This might well reduce the extent to which political will is bent to economic fear. The Greek situation today is therefore arguably more volatile than it was in 2011.

This is certainly not how it seems. The market reaction to Syriza’s election and Greece’s return to the repetitive circus of down-to-the-wire debt talks every few months has been pretty muted. The country’s ten year debt is priced at over 60 cents on the dollar, below the 80 cent level reached before last autumn but nowhere near reflective of the 74% loss incurred by bondholders in the 2012 restructuring. The Athens Stock Exchange index has fallen 24% over the past six months, but that is pretty tame compared to the 69% fall it suffered over calendar 2010 and ’11 – and it is actually some 3% up on the year to date.

The overall market view, then, seems to be either that the current talks are nothing to worry about, or that Grexit doesn’t matter very much. And besides, the Euro Stoxx 50 is up 11% since the end of 2014, last week’s GDP data for the eurozone was a little ahead of expectations, today’s stronger-than-forecast PMI numbers suggested the outlook here remains bright, and while it has bounced a bit recently the oil price remains about 45% lower than where it spent the first half of 2014. (If you add up the individual members you find that the eurozone, not the US or China, is the world’s biggest oil importer by some distance.)

It appears highly unlikely that another major debt restructuring is on the cards for Greece (as opposed to changes to its existing terms). On this basis the relatively sanguine market view looks right. Prime Minister Tsipras could of course decide to give the world a shock, but it remains clear on balance that this wouldn’t do his country much good.

20/02/2015 at 4:47 pm

US Preeminence

That was the title of a 2015 outlook piece from a major American bank out earlier this month. The piece itself had its strengths as well as weaknesses but what is beyond doubt is that it stands foursquare behind the prevailing consensus. The US economy will soon be global growth leader (in the developed world at least) – awesome! The dollar will continue to appreciate on the back of this and the monetary tightening it will bring with it – woohoo! Stocks will go up, though let’s not get carried away here; there won’t be another 2013, but maybe we’ll get last year all over again (S&P 500: +11.4%).

At present these views are so unanimously held as to represent truisms. Wall Street has been bullish on Uncle Sam for some time, fuelled at first by the shale boom and projections of US energy independence, but today the positivity is much broader and universally shared. These bull views are not wrong, exactly, but it seems pretty clear that the case is now being enthusiastically overstated.

Let’s look at growth first. Yes, the average forecast for this year is for real US GDP to go up by 3.2%, outpacing Japan, Europe, the UK and elsewhere. Uncannily enough, however, 3.2% is exactly the level of the post-war trend. So what is being feted is a return to trend growth – not, in fact, as terrifically exciting a phenomenon as all that. And should the forecast prove correct this calendar year will be the first over which growth even reaches that trend level since 2005. Yee-haw.

This is not to be sniffy about American prospects. Some of the structural strengths identified in the note referred to at the outset (Goldman Sachs, since you ask) are absolutely valid, and important: the quality and global reach of the tertiary education sector, the connected vitality of innovation and so forth. But the market effect of these things is the very definition of “long run”, and they have been features of the landscape in the USA while markets and the dollar have got up to all sorts of things, not all of them good for investors.

No: the real point concerns sentiment. Only three short years ago there was still talk over the Atlantic of jobless recoveries; the autumn of 2011 was a time of near-universal pessimism and panic, even at the Fed; over the summer it emerged that growth had stalled; Congress was trying to appear to threaten to push the country into default; S&P downgraded the sovereign debt rating to AA+; and of course stocks crashed.

This was an excellent time to be buying American assets.

Sentiment is a tough thing to measure. But if you remember the 1990s you will recall that they really were a time of optimism – even “exuberance”, as one famous proclamation had it. Does the shale boom really measure up to the rolling out of the internet? Is a return to trend levels of economic growth really as “preeminent” an accomplishment as victory in the Cold War? And best, perhaps, that we don’t mention Clinton-era phenomena such as budget surpluses and consistent real growth of well over 4%.

The truth is that the circumstances in which the US finds itself today are good, but they are nowhere near as exciting as some appear to believe. There may even be tiny hints of caution in today’s GDP print (ever so slightly lower than expected) and the current earnings season (reported EPS for the S&P 500 are up only 3% on the previous year with almost half the index having declared).

It is idle to speculate too heavily on these kinds of outcomes. But just as sentiment provided investors in risk with a great opportunity in 2011-12, so now does it pose a potential threat. There is simply not all that much room for disappointment – should there be any, of course.

There are some who favour massively overweighting the US just now at the expense of what they see as conspicuously less gilded markets. It is not clear that this is sensible advice.

30/01/2015 at 4:18 pm

The Deflationary Threat

Much like last year, 2015 has got off to an exciting start. This blog identified interest rates as an important market theme, and though the Fed (and to a lesser extent the Bank of England) have been positioning expectations for a tightening of policy at some point it has been the new emergency monetary measures in Europe which have dominated attention thus far. Mr Draghi can take much of the credit for turning around sentiment on the sovereign debt malady in 2012, attracted further limelight last year by introducing negative deposit rates among other things and yesterday, of course, officially announced the start of quantitative easing in the eurozone. As with his other announcements this one has been taken well: the Stoxx 50 has risen by more than 10% over the last couple of weeks, bonds in Greece and elsewhere in the eurozone periphery have found some support and he will not mind that the euro, which has fallen by 3% against the dollar in the last two days alone, now stands at levels last reached in the summer of 2003.

Fears over the prospects for Europe are nowhere near as powerful as they were in the days of the Bond Market Terror when Draghi took the helm in November 2011. Today the fear is that the Continent will follow the “deflationary spiral” which sucked the Japanese economy under the waves for so many years, as people defer spending decisions, companies delay production, activity thus contracts (exacerbating the price effect) and the bells of doom generally begin to toll.

Or so the story goes. The Japanese experience was / is not actually like that. After the collapse of the 1980s economic and investment boom the stock market crashed in 1990, growth began to slow, and the Bank of Japan cut rates accordingly. The yen, however, was allowed to appreciate by over 50% on a trade weighted basis at the same time, more than compensating for this effect and ensuring a recession which saw growth move sideways for two years. Annual inflation, on the other hand, didn’t turn negative until 1994 – and in 1995-6 the economy motored along just fine. The first bout of Japanese deflation was therefore a symptom of the malaise, not its cause.

Then came the 1997 collapse of the Asian tiger economies, the Japanese banking crisis and another unwelcome period of massive yen appreciation. It was at this point that the zero-interest rate policy, “ZIRP”, came along. Then of course there followed the collapse of the TMT boom. So the level of Japanese real GDP moved sideways for five years this time (1997-2002). Although deflation did not begin in earnest until the 2000s, its association with Japan’s “lost decade” had become intractable, and the idea of deflation as a cause of her problems, rather than a symptom of them, an established part of the market narrative.

Looking at this another way, Japan is not the only economy to have experienced deflation in the recent past. Did you know that Switzerland, for example, saw a pronounced deflationary period from 2011 to 2013? Or that Singapore officially entered deflation a month before the eurozone? Nor is it only countries beginning with “S”: Israel has been deflating quite cheerfully since the autumn, joined last month by neighbouring Lebanon. None of these places are forecast to suffer Armageddon as a result.

One could also mention that “core” inflation in Europe remains positive … but by this stage the point ought to be well made.

Of course, a lot of market narratives can become self-fulfilling. For this, if for no other reason, it should come as a relief to see the latest round of “open mouth operations” at the ECB enjoying a positive reception.

As a last word on this subject – for now! – it also salutary to observe what happened to Japanese asset pricing during the first decade of this century. Ten year bond yields did not tend to trade at 0.4%, for example, even with deflation all around, QE in train and the policy rate at or near zero. Nor did equities experience a terminal spiral of death, or the yen perpetually depreciate. But all of that is a much longer story.

23/01/2015 at 4:42 pm

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