Posts tagged ‘tail risk’
We are now comfortably over half way through 2014. After a shaky start, and despite persistent jitters, much of the year was actually quite undramatic for financial markets. For a while it looked as though asset prices were struggling to establish any direction. In some areas this has remained the case. But since the spring there have been signs of movement, and these have been mostly supportive of the pricing of risk.
Starting with assets which have prolonged their mundanity: gold, at just under $1,300 an ounce, is priced almost exactly in line with its average for the year to date. Despite some volatility over May and June it shows no sign of directional movement whatsoever. The story is the same for oil, which spiked up as news broke of the crisis in Iraq but has since fallen back again to about its average level for the year so far.
Government bonds have not been terribly exciting either, at least in general. The ten year gilt yield, for instance, has moved within a range of 2.5%-2.8% since mid-February and currently stands at 2.6%. On the other hand the ten year German bund yield hit a record low of 1.15% only this week, having tumbled from 1.94% at the end of 2013. In recent years this might be seen as a reaction to crisis fears in Europe, but this time round it would appear to have more to do with declining inflation and anticipation of the ECB’s policy response: bond spreads in the peripheral eurozone countries have, without exception, tightened over the year to date.
In fact, credit markets generally have been giving the strongest risk-on signals. High yield spreads, as measured by the Markit iTraxx Crossover index, narrowed with conviction as the year wore on. Twelve months ago they were above 4%. Now they are under 2.5% and have closed below 2.2% in the last few weeks. At that level they were almost exactly in line with the average for 2006 when the Great Recession was a mere glint in the US mortgage market’s eye. Consider also that only this month we saw a default event materialise in the banking sector of a south European country. Just imagine the effect this would have had on markets in late 2011 / early 2012. In this case spreads came off their lows but by no stretch of the imagination has there been any sign of real panic. The transformation is astounding.
Equity has found some tentative direction too. As late as mid-April, year to date returns for both the MSCI World Index of developed-world markets and the MSCI Emerging Markets Index stood at an unbeatably dull zero. But since then they have now risen to 7.3% and 9.4% respectively.
Past performance, as they so rightly say, is no guarantee of future returns. There are several “known unknowns” to contend with as the year continues. Political risk in the Middle East and Ukraine shows no sign of subsiding. Earnings growth, especially in Europe, needs to come through to support equity markets at current valuations. And the ancient phenomena of price inflation and monetary tightening could provide unsettling surprises as the quarters grind on.
While there is nothing to stop them being unwound, however, these signs of a rediscovery of market direction are cautiously encouraging. Looking forward the safest observation we might make is that the behavioural inconsistency in some asset prices should not be expected to persist indefinitely. Bears, as well as bulls, now have a little more scope to position themselves accordingly.
We noted last time that some of the popular analysis of market jitters doesn’t really stand up to scrutiny. So far this month those jitters have eased. But one of their possible sources has persisted.
The punishing winter weather in the US has been devastatingly persistent. Record low temperatures have seen a long series of severe snowstorms and associated transport disruption and this pattern is expected to continue.
As well as flight cancellations there have been some sharp effects on energy markets. The shale revolution has transformed the domestic American supply picture for gas and oil, but the harsh winter has blown it back for now. Natural gas prices have spiked back to levels not seen since early 2010 and the nation soon expected to be the world’s largest oil producer has been reduced to importing heating fuel from Europe.
Inevitably, the wider economy has not gone unscathed. Most obviously, consumer activity has felt the chill, with retail sales data disappointing and fears that the inflationary effect of heating costs will see this persist into the spring. Employment numbers have been more mixed but there seems to have been a temporary effect on hiring too.
It used to be said that when the Fed sneezes, the world catches cold. Fears over tapering remain, but it is yesterday’s news. In this case it is the US which has been caught out by a nasty cold snap. Activity has suffered, the shale phenomenon behind much of America’s economic optimism has had its limits tested – and even Wall Street titans can’t like trudging under damp grey skies through sleet.
A white winter doesn’t make a proper black swan. But it has had an effect. The US recovery has been a self-conscious beacon over recent quarters; Wall Street dominates cross border capital flows in emerging markets; and Americans have even been calling time on the Great Rotation.
With the UK suffering terribly in some places from flooding and tidal surges we know that brutal weather should not be dismissed as a storm in a teacup. But we also know that in time, even the worst storms do blow over.
“As a bear case it is a tempting proposition. Just when we have all started ignoring Europe, a new bailout or political upset will come along and upset the apple cart again.”
So this blog speculated all of seven days ago. Since when, two shock ministerial resignations in Portugal threatened to bear the point out directly.
Markets appear to be considerably less fragile than they were a couple of years ago, but this is still the kind of surprise they can do without. On Wednesday the Portuguese stock index fell by more than 5% and the country’s ten year bond yield rose from 6.5% to an intraday high of almost 8%. It looked as though the European drama was about to begin yet another deadly act.
Perhaps it was fortunate that attention was distracted by revolution in Egypt that very day. This was received more favourably by local markets, with the Egyptian Exchange index 7% higher on yesterday’s close. And as of this afternoon, negotiations in Portugal seem to have headed the crisis there off: bond yields have settled below 7% again and the equity market has recovered about half its lost ground so far. (German finance minister Wolfgang Schäuble did make one ominous comment though: “I think the euro is now viewed on the world’s financial markets as so stable that domestic political situations in individual countries … don’t mean a crisis for the stability of the euro as a whole.” So we can’t be out of those woods yet.)
If nothing else, the relatively sanguine response to these events tells us something about market confidence. The absorption of Portugal’s left-field political turmoil in particular is worthy of note. Above all, however, they remind us that we cannot plan for tail risk, and we certainly cannot be sure exactly what the view round the next corner is going to look like once we get there.
Lacking omniscience, we have a clear choice. We can allow ourselves to be spun into a dizzy panic by day-to-day news flow and volatility. Or we can follow the fundamentals, watch what happens to pricing – and try not to get so thunderstruck we lose the conviction to exercise our judgement accordingly.