Tin hat or sun hat? A return to volatility this summer?

Summer could bring greater volatility than we’ve seen of late, certainly in energy prices and possibly across other markets making it tougher to get equity and debt away. Beyond the short-term crises is the much bigger problem of the slow grind of the Eurozone recovery, still hampered by its still heavy debt burden – time for stronger action?

Tin hat or sun hat?

It’s officially summer, which has meant two things in recent years: jitters and downgrades. Will we break the cycle in 2014? Ostensibly, we’re enjoying a more robust economic and market environment, with more belief being expressed through M&A and IPO activity. Of course, there is a fine line between confidence and hubris in today’s liquidity soaked markets; but investor’s conviction that Mario has their backs forms some buffer against bad news.

But, if this drawn out recovery has taught us anything it’s not to count our chickens. There are still candidates to be this summer’s Eurozone – even the Eurozone could still be this summer’s Eurozone – and its long-term outlook is still one of our most pressing concerns.

I won’t be the one to disappoint you any more…

The first candidate for a summer upset has noisy headlines, but is economically small beer. The impact of England’s failure to progress in any fashion at the World Cup apparently cost the UK economy anywhere between £300m and £1bn. The wide band reflects disparities in expectations and the virtual impossibility of netting off lost BBQ sales verses extra cinema visits – not to mention ambivalent attitudes outside of England.

Whatever figure you choose, the impact isn’t significant, albeit with the negatives focused on sectors like pubs, supermarkets and bookmakers. Although, judging by an entirely unscientific car flag count, supporter expectations seemed well managed. Investors could give short shrift to any company who raised theirs too high.

Political upheaval, energy shocks?

More risk comes from the growing role call of unrest and “civil wars”. According to Barclays’ survey of over 900 global investors, 35% believe that geopolitical developments are the most important risk to financial markets over the next 12 months – moving ahead of emerging market growth and interest rate hikes.

There are conflicts of note across Africa and The Far East, but Ukraine’s and Iraq’s significance to oil and gas flow keeps them in focus. A fragile cease-fire in Ukraine has eased tensions, although there remains a question mark over gas payments. The Iraqi situation is more volatile, although in terms of the potential for oil price shock, two elements provide limited comfort: little supply disruption (so far) and the increasing diversification of international supply since the 1980s. Brent Crude has moved higher, but not dramatically so – and not enough to seriously trouble the mostly hedged airline sector. However, it’s tough to discount further escalation and it’s clearly an area to watch this summer.

Argentinean bonds – still Messi (sorry)

In terms of debt markets, Argentina is the main event. The Argentinean government is finally working towards avoiding the ignominy of defaulting on its default following the end of legal recourse. It has every incentive to settle with the 2001 holdouts, since a deal would surely open up international markets – they’re not fussy these days. However, negotiations are delicate, the clock is ticking and the total amounts involved significant at more than half of Argentina’s reserves.

Argentina has 30 days grace after next Monday’s deadline to do a deal and pay. If it fails, the domestic impact won’t be pleasant, but is unlikely to be as dramatic as the corralito due to the existing market exclusion and lower levels of foreign debt – c.13% of GDP. The saga has surely rumbled on too long for default to be a shock to global markets and should only cause ripples – unless it combines with other forces….

Rate hikes – the guessing game continues

The obvious candidate to turn ripples into waves is an outbreak of “taper tantrum” II. Emerging economies have had time to plan and a US rate rise won’t come until some months after the end of the taper – due this autumn. However, emerging market economics are scarcely better and adjustment will still be tough. Last summer showed confidence can shatter on stronger words as well as actual deeds.

The Fed will need to tread carefully. It might say it only sets policy for the US, but it’s not naïve enough to believe it does. Bank of England decisions would normally have less international impact, although the first rate-hiking vote from an MPC member could spark frenzy if investors see this as a portent for the Fed. This could come during the summer, although recent hawkish comments looked designed to wrest control of the narrative rather than a serious indication of an early 2014 move. Recent minutes indicate that MPC members see little economic imperative to raise rates this summer unless wages pick up.

Short-term crises…. long-term problems…

These risks (and other curve balls) should be manageable in the current economic and market context. Enough to allow sun hats – absent an especially toxic combination – but keep the tin hat close by. Companies should prepare for increasing volatility across energy and other asset classes. Central banks are certainly gearing up to shift their allocations. In a recent survey, almost 60% of central bank of reserve managers believed the Federal Reserve’s scaling back of monetary stimulus, in particular, will have a “major impact on reserve management at a tactical level,” forcing them to shorten the duration of fixed-income holdings and diversify investments. The survey included 69 central banks controlling 57% of global reserves. It’s hard to imagine that debt will ever be much cheaper.

Beyond these short-term concerns, it’s the long-term outlook for the Eurozone, that’s troubling us. It is telling that in contrast to the rapid fall in yields, the credit ratings of troubled Eurozone sovereigns have barely moved. Investors have used the kind of mental gymnastics that eluded Winston Smith to buy sovereign debt with cheap cash – pushing aside thoughts of the slow growth and low inflation driving those low interest rates. Private and public sector debt in “peripheral economies” remain near record highs in both percentage of GDP and absolute terms. The deleveraging journey has barely begun and it’s getting harder and harder to foist austerity on tired populations when there is very little light visible at the end of the tunnel. High debt burdens will drag growth for many years to come.

Cheap interest rates can only do so much, when households and companies have no appetite for more debt. Without some form of monetisation, the Eurozone looks to be drifting towards a Japanese scenario of low growth and low inflation – with the added complications of higher external debt and popular protest. It’s tough otherwise to see where growth and investment will come in the region – with further implications for banks wanting to dispose of troubled loan books. According to the IMF, the region’s stock of non-performing loans has doubled since the start of 2009 and now stands at more than €800 billion – with just 6% sold so far.


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