I saw a wonderful cartoon this week, which had two kids (one of whom is holding
a needle close to a balloon) approaching a balding middle-aged man reading one
of the financial newspapers, with the caption "Watch him jump". Replace the
adolescents with today's politicians (actually scratch that, most politicians
are still adolescent at least as far as their mental growth is concerned) and
the balloon as burst; you have the perfect picture of what happened in the
markets.
Anyone looking for the "new normal" doesn't have to look too far from the
events that drove this week's trading so far. In summary, academics and
economists (reportedly there is a difference between the two) have been
searching for a "new normal" for the world economy as it attempts to recover
from the crisis of 2007.
What they are missing is that the "new normal" isn't going to be
defined by the relative economic growth of various countries or the dynamics of
inflation; what will define it (as is increasingly becoming clear) is the
return of absolute, gut-wrenching volatility that makes investing a permanent
state of siege. In that environment, investor behavior is reactive rather than
proactive and surprises abound on both the up and down directions.
Welcome to a new world where the definition of order is a state of continued
chaos.
What caused this meltdown?
The primary policy response globally since October 2008 has been Keynesian,
that is, to throw good money after bad in the fervent hope that any resulting
inflation would help to reduce the present value of debts while creating new
asset bubbles that could encourage consumers to return to their big spending
ways. For a while, the strategy seemed to have worked, what with all manner of
risk assets rising over the course of 2009. The indicator that the financial
media are most obsessed with is the stock market; and unfortunately for the
headline-writers and other cheerleaders for the global economic
"V-shaped-recovery" malarkey, that isn't looking in good health now.
As things stand today (May 20), European stocks (Euro Stoxx) are down 13.35% on
average for the year (25% down in US dollar terms) within which there is a
significant variance across the various countries - Germany's DAX index is only
down 1.5% (15% in US dollar terms) while Greece (-27%) and Madrid (22%) have
done horribly. In Asia, the Nikkei is barely flat for the year in US dollar
terms while being down 5% or so in the local currency; for the Hang Seng index
in Hong Kong the decline is 10.6% for the year. The US stock markets, which led
the rally last year, were basically flat for the year on Wednesday; declines on
Thursday pushed the S&P index down about 2% for the year.
The first polemic: Buyers of risk have the power in the markets
today precisely because governments have abrogated fiscal responsibility. In
that context, when you are in charge of a government that needs to borrow tens
of billions of dollars from the markets every day, it may be a good idea
neither to startle people nor indeed to lecture them. It doesn't look to me
that German Chancellor Angela Merkel or President Barack Obama have got this
particular memo, for they have done precisely the opposite thing.
The second polemic: Governments around the world and particularly
in Europe can pretend that this bout of crisis is all about the evils of hedge
funds, speculators, short-sellers and whatever have you; the truth is closer to
home. Over-leveraged institutions and indeed instruments are prone to rapid
bouts of volatility. Any solutions that fail to address excessive leverage
would likely buy time and do nothing else. Governments cannot get away with
this bluster much as they try to paint new villains into their own ghastly
policy responses.
The third polemic: This relates to the political classes - no offense but do
shut up. Buyers of risk (see polemic number one) have no appetite for lectures
and have been forced to do more work on ensuring that whatever they buy is
worth the trouble from a risk perspective. Add a whole bunch of unrelated
political noise to these complex equations - and that means your speeches, my
dear politicians - and what you have is the makings of a buyer's strike. And if
that happens ... oh well, let's not consider that, okay?
Recent developments
This week would certainly never be categorized as "slow news" by any stretch of
the imagination. Financial markets were abuzz with developments most of which
proved extremely expensive for investors who owned risk (or "long" in the
market parlance).
To be sure, there were enough other events that were non-financial: the
continued oil spill in the Gulf of Mexico, the tragic events in Thailand, the
escalation of rhetoric between North and South Korea over the torpedo incident
and the new nuclear deal signed by Iran to defuse tensions. Unfortunately for
investors, all of these events were considered strictly with the jaundiced eyes
of those who panic; in other words, all of the above compounded the negative
tone of the markets (admittedly most of the above is actually bad news).
A look here at the main developments from a financial perspective:
German short-selling ban
The biggest mover of the markets was the announcement by Germany on Tuesday to
disallow short sales of European government bonds, "naked" credit default swaps
(CDS) and the short positions in the stocks of Germany's 10 biggest financial
institutions.
Market reaction ranged from the incredulous to the irreverent (example - a
popular e-mail carried a fake headline as its subject "Germany bans goals
against its team in the World Cup"). There were a lot of details left to be
ironed out by the announcement made by the BaFin agency; not the least of which
was how the new rules were going to be enforced and its geographical scope. The
confusion only deepened when other European countries, including France and the
United Kingdom, denied that the rules were applicable across the region.
As things stand, the rules, if adopted across Europe, would carry significant
but unintended consequences. Bear with me for a moment here, but the complexity
below is necessary to drive home the point about how clueless today's
government officials are with respect to the market.
Take the ban on "naked" CDS; under the rules, no one may purchase protection on
a European government without owning underlying bonds. Assuming that everyone
complies, there is still a very big problem, that is, that while bonds carry
pretty much any maturity date, most CDS contracts are set to mature in
quarterly intervals (20th of March, June, September and December).
So if you owned a bond that matured on say February 10, 2015, you would want to
buy protection close enough to that date; hence to March 20, 2015 -
technically, the rules would disallow this CDS because your contract has a
"naked short" exposure on the European government for a month longer than its
maturity. Well, why couldn't you get a CDS to mature on February 10, 2015 -
because the dealers would consider it illiquid and prefer not to trade with you
for the date. Your other alternative would be to purchase protection until
December 20, 2014; however, in that event, you as the investor would be left
with a "naked long" position for 40 days (which, given this year's meltdown in
European government debt, would be unacceptable).
The solution then would be for you to purchase a bond that matured exactly on
the CDS rollover dates. This would in turn force governments around Europe to
issue bonds that only matured on the appropriate CDS contract dates. Imagine a
government having maturities of say 50 billion euros in a given year; that
would mean going to the markets on just four days of the year with 12.5 billion
euros each time (and remember that all other European governments would also be
approaching the market for funding on those same days). The net result is that
volatility in the bond markets would increase, not decrease due to such
maturity concentrations.
(Yes, I am aware that there are many other solutions, but the point here is to
highlight linear interpretations of ill-considered laws).
Other regulatory risks
Just to make things interesting, regulatory risk has increased manifold over
the past week:
The European Union is proposing a comprehensive hedge fund regulation that
would target the operations of hedge funds across the continent and also limit
the ability of European citizens to invest in hedge funds alongside. This is
part of the political noise from Europe in recent days but is thought to have
significant (adverse) consequences for market liquidity if it is adopted across
Europe and particularly by the UK.
There is the much-discussed financial reform bill in the US that is making its
way through the process with more than its share of headlines; it was finally
approved in the senate on Thursday and must now be merged with a House of
Representatives version. It is expected to be signed off by early July. Among
other things, the bill calls for new ways to watch for risks in the financial
system and writes new rules for complex securities. It would also impose
restraints on the large, interconnected banks and call for proof that borrowers
could pay for the simplest of mortgages.
The impetus towards a global bank tax has gathered momentum, with both Germany
and the UK proposing different variations of the idea. This is a
straightforward negative for the share prices of banks but as it highlights the
notion of governments scrambling to impose retrospective taxes obviously to
improve their fiscal positions the markets are looking at other sectors,
including metals, mining, energy et al.
Poor economic data
Forget all the market noise; one can always depend on fundamentals, right? Oh
well, not this week. Even as the US produced a surprise deflation print that
suggested that sales were only happening at the expense of margins (thereby
rendering questionable the market expectations of profits), there was worse
news from employment, when claims increased a surprising amount for the week.
Elsewhere, the UK produced a surprisingly aggressive inflation print that
suggested the counter-effects of the marked decline in the pound sterling for
the past few months as the country effectively imported its inflation; this has
negative consequences for Europe, where much the same combination of
fiscal/quantitative expansion and currency devaluation is happening now.
Commodities, Australia, miners and metals
Following from an Australian government's initiative to tax commodity exports
in order to buttress its finances, prices have become more volatile both for
companies operating in the business and for the actual commodities as financial
markets grapple with the potential consequences. There is now elevated risk
that other major exporting countries such as Chile, Brazil and Canada may
follow suit, in turn making commodity prices more volatile.
The volatility itself is being fed by the decline in stock markets that has
created a negative spiral of wealth for individuals, a postponement of large
initial public offerings and share placements, including potentially the $25
billion deal mooted by Petrobras; and a general re-rating towards a negative
view.
In credit markets, this has translated into significant bouts of panic. A
number of large commodity-based companies have large outstanding lines of
credit from global banks under which they would be able to draw down billions
in funding whenever required. Given that banks are now paying much more for
their funding - particularly if they are based in Europe - and the commodity
companies have less illustrious future earnings (apparently), the urge to hedge
has vastly increased, thereby driving CDS levels sharply wider.
Zero-sum game exposed
One of the factors keeping the US and emerging markets ticking away in the
beginning of the European sovereign crisis was the notion that market flows
represented a zero-sum game, ie that outflows from Europe would help market
performance elsewhere.
This has now been exposed as a lie as markets have become more cognizant of two
constraining factors - firstly, the economic effect of fiscal tightening being
imposed across the continent, which would reduce aggregate demand for exports
from the US and emerging markets; and secondly, the collapse of the euro, which
dramatically escalates the competitive position of exports from the continent
(at the expense of the US and emerging markets).
Thus, rather than a zero-sum game, the decline of Europe simply transmits
itself to the rest of the markets as a negative.
The way forward
Much as this may seem counter-intuitive, the lesson for governments globally is
to do as Germany did, not as they say. If one considers the experience of the
country embracing real wage deflation from 2000 to improve its competitiveness
and eschewing leverage in favor of a gradual build-up of productivity, it
appears almost logical for a number of other countries that have similar
demographic situations (much of Europe, the US and others) to follow.
The trick is to avoid listening to the German government as it stands today;
where meaningful reforms are being sacrificed at the altar of political
expediency in favor of some neighboring countries, such as France. With Germans
voting against the current political equations, the rhetoric has become
shriller as the attacks on hedge funds and naked shorts make clear.
Markets have woken up to the risks of the excessive debt build-up by
governments globally. This will have credit consequences (ie some countries
will have to restructure their debts) that then flow to interest rates (as bond
yields become steeper or rise) and from there to the rest of the economy
(savings will be forced higher, consumption down). These are precisely the
objectives that policy responses should have focused on since the beginning of
the crisis - it just so happens that when governments avoid tough action,
markets go in and do it for them.
The larger lesson is that thanks to the counter-intuitive and eventually
counter-productive actions of the Keynesians running global governments today,
chaos is the new order; a constant state of crisis is the new
normal.
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