Grey swans prompt market rethink

Grey swans prompt market rethink

There’s plenty to chew over this week. The rising possibility of Scottish independence, the ECB’s decision to go (almost) all in to avert deflation and stagnation and disappointing US jobs numbers have forced an investor rethink.

Break-up and deflation fall under the category of “grey swan” events – conceivable events, with unpredictable outcomes – “known unknowns”, as it were. The net effect of this enhanced uncertainty has been to push back UK and US interest rate hike expectations and to weaken both sterling and the Euro against the dollar. The US jobs recovery might be flagging, but that feels like small beer in this company.

And so the uncertainty drags on. Certainly in the Eurozone, where its saga appears to have many more acts. Perhaps even in the UK, if the Scottish referendum vote is very close. UBS have raised the chance of a third ‘Québécois’ outcome – a scenario that falls between a decisive Yes/No, where markets continue to price in the risk of further referendums.

ECB last throws…and last throes?

The Economist wrote last week that the risk that a country decides to ‘storm out’ of the Eurozone is ‘rising’. Still? Yes, this came before the ECB’s latest actions, but the risk is still there.

Of course, it’s not all gloom across the region. There are positive flickers of life, from the Irish recovery to signs of recovery in Spanish house prices. However, the bigger economic picture is truly alarming. Last week, the ECB once again downgraded its 2014 growth and inflation forecasts to 0.9% and 0.6% respectively – averages that conceal pockets of stagnation and deflation. In this context, the action taken by the ECB to lower interest rates and begin an ABS purchase programme is an understandable, normal policy response – with the added bonus of weakening the Euro. However – as we’ve said before here – the global context is far from normal and we’re far from convinced that the chief problem in the Eurozone is the price or availability of credit.

According to JP Morgan, the G4 banking system already has excess reserves of around $4.5t i.e. reserves commercial banks have with central banks in excess of what they need to meet usual liquidity needs. There’s a risk that the ECB’s actions could further perpetuate a culture of dependency and create a disincentive for reform. Without structural reform, growth prospects will remain limited and businesses won’t demand more credit.

And, is this action the ECB’s last throw of the monetary dice? Interest rates can go no lower. Hints of resistance to ABS purchases raise the possibility this is as far as the ECB can go. What if it can’t deliver on QE hopes?

The Eurozone still needs to act radically on debt and to take action to drive the structural reform necessary to promote strong growth and avert deflation. The ties that bind the Eurozone go beyond finance. They weave back into hundreds of years of turbulent history and are rooted in the belief that closer bonds promote peace. However, this shared history can’t hold the region together indefinitely without an economic imperative. Electorates are already wondering what the euro ever did for them – they need growth and jobs to convince them to stay.

Private equity outperforms

Liquid markets have certainly been a boon for private equity. EY’s ninth annual European private equity study shows 77 exits in 2013, versus 61 in 2012, aided by revival in IPOs and secondary markets. IPO exit activity reached its highest level since 2006 in 2013, with 13 companies floating compared to just three in 2012. This rise in floats grabbed the headlines, but secondary activity also increased as debt markets opened up. Last year, 55% of exits were to other PE firms’ companies — a notable increase from the 38% recorded in 2012 and the highest share of exits since 2007. The rate of corporate purchases remained low in 2013 – in part due to competition from these other avenues. However, exit activity has also been strong in 2014 and, with a strong pipeline, should continue to be so in the rest of the year.

Our study also highlights the positive effect of private equity ownership. The data shows PE creating superior financial returns for investors, even after discounting for additional leverage and stock market performance. The most important source of PE outperformance came from faster profit growth, driven by initiatives to increase revenues and operational efficiency. Gross investment returns from PE-backed companies outperformed comparable publicly listed companies by a multiple of over three times between 2005 and 2013.

New term, new challenges…

New term, new challenges.

There’s a ‘back to school’ feeling this week with excitement and trepidation obvious in the markets. Activity is picking up after the summer break; however, the recent escalation in geopolitical tension and conflict demands a measure of caution. Meanwhile, we’re moving directly into the uncharted territory of an extraordinary countdown to an extraordinary wind down of an extraordinary level of central bank support. Plus, there’s an independence vote for Scotland that’s looking a mite closer than it did a few weeks back.

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Deflation, deflation, deflation

Deflation, deflation, deflation….

Plus ça change, plus c’est la même chose – the more things change, the more they stay the same. There’s a change in ECB rhetoric, but we’re effectively looking at the same solutions. Markets are happy as long as someone is hinting at money printing – doesn’t matter whom or why. The disparity between the Eurozone and UK/US monetary policy looks larger than ever on paper, but a few nonconformist votes and adjective changes don’t amount to a hill of beans just yet.

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Work in Progress

Work in progress

There’s a disconcerting chill in the UK’s ‘summer’ weather and a chill in the global economy too. The all-pervasive central bank policy filter and the ebb and flow of geopolitical worries often blurs the impact of poor economic data. However, there have been so-so figures from the US, Eurozone and Australia amongst others in the last week, highlighting uncertainties in the growth outlook and the prospects for consumers in particular.

Without wanting to overplay the downside, given the undoubted improvement in 2014, the recovery is still a work in progress. Monetary, fiscal, regulatory, electoral decisions will have a large impact on the next stage and there is plenty for investors to keep a weather eye on in the next 6-9 months.

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Serious season: high yield bonds remain in the spotlight

Serious season

Was there a time when ‘news’ just stopped in summer? A time when only ‘silly season’ stories of crop circles, pigs on the run and killer chipmunks prevailed with little else to trouble us. If those halcyon days ever existed, they’ve not returned this year. In common with recent summers, markets have wobbled – not to the same extent as the Eurozone/tantrum years – but with a disturbing geopolitical edge. Moreover, there is a definite fin de siècle mood building, especially in high-yield debt, as we continue THAT countdown.

Nervy investors have treated good and bad news with Kipling-like equality of late – at least in the sense that they have sold on both types. Although, good news can no longer be judged on merit since it’s now the harbinger of those higher interest rates. Of course, they won’t be a surprise, but that doesn’t mean the impact is certain….and it’s that uncertainty that makes it nigh on impossible to ‘price in’ the effect.

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Questions, Questions…

There are many questions to ponder this week. From the strength of the US recovery to why markets seem only periodically concerned with geopolitical turmoil – is everything a buying opportunity these days? Are junk bonds our canary? Is Banco Espirito Santo the last European bank casualty or a taste of things to come?

US springs back – but how far forward?

US employment and GDP data always loomed large on the economic calendar, but for obvious reasons they’re now analysed with a far fiercer intensity. Coming together – as they did last week – they might have shifted the Fed’s tightening timetable. But, actually the two data sets pretty much ticked the Goldilocks ‘good, but not too good’ investor box, i.e. growth, but not early interest rate hiking growth.

The first estimate of annualised GDP growth of 4% in Q2 – combined with an upgrade for previous quarters – certainly beat expectations, sparking a minor sell-off in anticipation of earlier monetary tightening. However, inventory growth made up a third of this impressive expansion, with the US economy playing catch-up after a frozen Q1. Meanwhile, payroll data showed job creation above 200,000 for the six consecutive month, but the figure was still a little below expectations.

So where is the US economy? Growth is more secure and stronger than 2013, with expansion underpinned by a strong rise in consumer spending – and more vitally – business investment. Faster growth combined with flattened Q1 expectations helped US companies to beat expectations at the half year (whilst UK companies continue to miss). However, wage and job growth remain muted and it’s here that the Fed will likely focus, keeping us on track for Autumn tapering and mid-2015 rate rise.

With of course, the usual caveat that past performance is no guarantee of future growth – not with tricky mid-term elections to navigate or the recent intensification in global conflict, which is having such a devastating impact on so many lives.

Geopolitical risk – why so little market reaction?

Around 12% of the world’s population now live in war-effected countries, according to JP Morgan. So why has there been so little market reaction, beyond the occasional dip? We’re in a mild risk-off mode this week, but recent patterns suggest markets could soon spring back so long as the expectation of continued central bank support in 2014 holds.

The sanguine market view is partly because investors make decisions on different numbers. A far smaller percentage of the world’s GDP and market capitalisation comes from war-affected countries – 3% and 0.7% respectively, according to JP Morgan. Moreover, whilst around 9% of oil reserves are in effected countries, those in Iraq, for instance, aren’t currently in a warzone.

Reaction to Russian troop movements has pushed the government’s 10YR benchmark bond to 9.82% today, the highest since 2009. However, until recent days we’ve seen only muted market reaction to the tighter sanctions against Russia. To some extent, again, this reflected financial realities. Funding costs have risen for those affected, but Russian companies had already begun to look east for finance and most of the larger companies have substantial cash piles to call upon – enough to cover their refinancing needs.

It’s these substantial financial buffers – in the corporate, financial and government financing – that means Russia is unlikely to face a liquidity crisis in the near-term, according to Moody’s. However, prolonged sanctions will “amplify the long-run downward trend in the country’s growth potential”. Western companies are already pulling back in anticipation of increasing red tape and lower consumer spending.

Dumping the junk?

One asset class may be starting to anticipate the move to a new monetary era. Investors pulled a further $1.5bn from US high-yield (HY) bond funds in the week to July 30, according to the latest Lipper data, marking the third straight week of outflows. In the three weeks to July 30, investors withdrew $5.5bn, the worst performance since the “taper tantrum” of June 2013.

It seems unlikely that this is just a blip, but three weeks of outflows doesn’t necessarily signal an imminent major sell off. Investors know they are not being properly compensated for risk, but there are so few alternatives and with default rates so low, HY remains relatively attractive. However, investors also know that liquidity in secondary markets is weak, despite strong primary demand. These new investors won’t stick around when the going gets tough and banks, under pressure from regulators, have significantly reduced their HY exposure. They won’t be there to mop up sales either.

Therefore, it makes sense to pare back holdings, taking the steam out of the market. If so, it’s pretty much what central banks and regulators are looking for at this point in the cycle.

BES – a singular case?

The bailout of Banco Espirito Santo (BES) has brought one of the EU’s toughest bailout resolutions yet. Portugal has used up almost €5bn from its €6bn contingency pot, leaving little available for more government assistance. The problems at BES surely raise the possibility that there are more problems lurking in the European bank woodshed – certainly more than were found in the last stress test.

Nevertheless, the cost of insuring against European banking defaults –even in junior debt – has barely moved. Is there an assumption that BES will be a one off? Or that ECB ‘s largesse will buffer against any shocks?

BES may turn out to be one of the biggest restructurings in this latter stage of the recovery, but it seems unlikely that it will be alone. Banks have made extensive preparations, writing down bad debts, raising billions in capital and shedding assets. However, EU banking problems still run deep. The IMF estimates that Europe’s stock of NPL doubled since 2009 and the AQR will require tougher action than most local regulators have required thus far. We expect more capital raising, deleveraging and possibly more rescues and bail-ins following the results of the latest Asset Quality Review stress test.

Hot markets, modified expectations

Feeling hot hot hot!

The UK’s weather has been hotter than Spain (apparently), debt markets –  until last week’s HY wobble – were as hot as 2007 (almost unbelievably), European earnings forecasts are cooling (all too predictably) and US earnings are heating up (artificially?)

Whatever the temperature, it’s never silly season here; but out there in the markets there’s arguably still a detachment from reality, which – as Mr Carney warns – may arrive sooner than expected.

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