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.
Euro HY canary chirps
High-yield bonds is an obvious place to view interplay of expectations. US HY funds recorded $680m of inflows in the week ending 14 August, a substantial improvement on the previous week’s record $7.1b outflow. So is this time to: “move along, nothing to see here”? No. Outflows continued in Europe and some ‘knife catching’ is inevitable.
There are so few places to find decent returns in today’s markets, that investors will find it hard to resist moving into high-yield when they see buying opportunities – even when prices appear to bare no relation to risk. And it’s this disparity and lack of liquidity which will encourage investors to exit – and exit fast – when there is a chance to take profits and when risks appear too great. Bottleneck risks amplify sell-offs – this is where the danger lies.
In Europe, local risks err more towards growth than tightening, but with familiar liquidity issues and the knowledge that the market isn’t an island. Outflows hit €665m last week, the largest since records began in 2007. Investors are now – if only periodically – pushing back and asking for higher coupons and tougher terms in response to changing times. S&P recently noted the extreme swing towards borrowers that has led the European ‘CCC’ benchmark to fall by more than 50% in the last four years. The fall is such that ‘CCC’ benchmarks are at the same level as ‘B’ in December 2009. Default levels are low, but not that low: 24% for ‘CCC’ against around 7% for ‘B’. We’ll be asking “where next?” in the coming weeks.
Japanese lessons – time for a recap
Bond market tractability has certainly eased the pain of the aftermath of the credit crisis. However, as John Plender of the FT notes, it has also contributed towards a level of Eurozone complacency that echoes Japan of the 1990s. There are obvious differences between the two economies, but that doesn’t mean there aren’t obvious lessons. The Eurozone should take advantage of a bona fide example as its anti-template and act whilst it still has time and the ability to reverse its descent.
Last week’s disappointing GDP and inflation figures highlight just how quickly the region is slipping towards stagnation. Peripheral nation growth picked up in Q2, but GDP fell or stalled in the three largest economies, whilst headline inflation dropped to just 0.4%.A worrying paralell inflation chart matches Japan of 21 years ago to today’s Eurozone, picking crisis points of 1990 and 2011 respectively.
It doesn’t need to be this way. The drift towards Japanification is to some extent self-imposed, with the potential for an equally damaging outcome. Japan offset its business investment fall with increased government spending. The Eurozone has focused on tightening fiscal policy, without the release valve of currency devaluation. Instead, periphera Europe has relied on internal devaluation, which has consequently lowered wages, demand and growth. The longer this continues, the tougher it will be to break free and the greater the region’s exposure will be to a potentially debilitating shock.
If Japan’s example teaches us anything, it’s the need for radical action. The Eurozone is at least attempting to deal with its banking problems, using the upcoming Asset Quality Review to force banks to recognise bad debts. It’s a painful and necessary step – but it will only be a truly effective one if the ECB goes the extra mile to help bring down the region’s debt burden to a sustainable level. Recent attempts to encourage more lending through cheaper debt are pushing on a string – the region has still to begin the process of deleveraging, it doesn’t have the appetite for more debt.
The ECB does have the capacity to lower debts through recapitalising banks or, going one-step further through debt forgiveness. There will undoubtedly be more than murmurings from Frankfurt at that level of money printing, but the actual amount required would be less than the scale of UK and US QE programmes. Of course, structural reform is also necessary, but Eurozone is fast running out of alternatives and time. For encouragement to be bold, look no further than Japan , where a minor rise in sales tax led to a significant setback in growth. When deflationary expectations get entrenched, they take a whole lot of shifting.
Rifling through the IPOs….
Are we seeing a change in IPO dynamics? At the start of 2014, when the market was hot, institutions eager and companies/sponsors more eager still, any talk of “dual processes” was mere ‘lip service’. Fast forward and it’s a little more complicated. The volume of deals passing through means investors and institutions can certainly be choosier when picking out IPOs. Only companies with strong balance sheets, great corporate governance and compelling growth stories need apply.
Institutions are also looking for the uncomplicated transaction – no need get involved in any ‘dual process’. However, increasing investor selectivity and cooler valuations means companies are more ready to consider the M&A route.This may explain why we’re hearing about ‘rifle shot’ processes. It’s where a buyer has a short window at an agreed valuation to do a deal and pre-empt an IPO that is set up and ready to go.
If only there was an agony aunt….
Please help….I can’t work out my central bank governor’s intentions. In May, he said he wouldn’t raise interest rates before 2015, but a few weeks later said I should prepare for 2014. Then last week he said slow wage growth meant no rise until 2015, before just a few days later saying actually rates could go up before real wages bounced back. I don’t know what to believe any more.
Dear Confused….it’s certainly baffling. I’d suggest some confusion about the state of the UK economy, or that’s he’s been trying to drop hints over the voting intentions of another MPC members – he can’t make this decision alone. This week’s low inflation figures may cool their ardour. I suggest watching the data instead of the man and preparing for further changes of heart.