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.