Market Review 11 May 2010

Markets crumbled last week under pressure of fears of Greek insolvency and risks for the Euro.  In light of developments this weekend, Mr Trichet’s comments following the ECB’s meeting last Thursday were thoroughly unhelpful.  He gave no indication of any intention to intervene in European government bond markets and by doing so thoroughly upset credit markets in Europe.

LIBOR rates rose and credit default swap spreads widened such that by the close of business Friday, there was a significant risks of a major European financial crisis. The situation on Friday was made worse by an apparent intraday meltdown in the US equity market.  The reasons for this remain obscure.  There was a sharp recovery in markets by the end of the day.

There was a suggestion that some trader at Citigroup had sold billions rather than millions of certain shares.  However, there is no confirmation of what may or may not have taken place.  Suffice it to say that electronic trading sale orders were clearly triggered.  Our activity on Friday was modest.   Having bought the new MST European Opportunities fund at the beginning of the week and hedged it on Tuesday, we closed the hedge on Friday afternoon.

The European Union/Eurozone/ECB package of measures announced at 4pm European time yesterday, just before the opening of the market in Hong Kong, is clearly designed to shock and aware and certainly the accompanying statement of European Union support for the euro is helpful.  The European Union and the ECB have clearly “owned” the euro, following its sharp recent decline (see below).

The European Union’s support package for Greece has been finalised and disbursements will be made to allow Greece to rollover the first tranche of its external debt by the due date of 19th May.  Not surprisingly, European longer dated bond yields have risen and the spread between peripheral European government bond debt and German government bond debt has narrowed.

The European stabilisation mechanism will provide up to €500 billion of financial help to member states that might need it.  Of this, €60 billion is immediately available under the existing EU budget, while the additional €440 billion will be made available through the creation of a special purpose vehicle to be funded and guaranteed by the member states.  It is expected that the stabilisation mechanism will be used alongside IMF support, which could add up to an additional €220 billion.

The ECB now anticipates outright purchases of Euro area public and private debt to address the malfunctioning of various markets and restore an appropriate monetary policy transmission mechanism.  No statement was made on the size or composition of these proposed purchases – presumably because this is still being worked out.

The ECB’s three month tenders in May and June will return to a full allotment at the 1% policy rate.  Additionally, a six month tender will be conducted in May, with full allotment at the average minimum bid rate of the weekly operations over the six month period.  The US dollar swap line with the Federal Reserve has been reactivated.  Dollar liquidity will be provided in the form of fixed rate tenders with full allotment against ECB eligible collateral.

Of all the interventions, the most dramatic is the proposed outright purchase of government debt, something which the ECB did not do even in the depths of the recent financial crisis.  These policy interventions collectively are huge.  However, it has to be stressed that neither bilateral/IMF loans nor central bank purchases/liquidity provision can substitute for the real fiscal adjustment that is needed.  They are intended rather to buy time and allow an appropriate fiscal adjustment to take place.

Unsurprisingly, therefore, the European Union also committed itself to ensure “fiscal sustainability”.  To add a little credibility to their slightly threadbare statement, Spain and Portugal committed themselves to ‘additional consolidation’ measures in respect of 2010 and 2011.

The market reaction this morning predictably has been a short squeeze in peripheral Euro, corporate emerging and high yield credit, a sharp rally in ‘risk’ currencies, be those peripheral EU, commodity or developing market currencies, and a sharp fall in  Bunds, Treasuries and to a lesser extent gilts.  This is standard short-term rough and tumble.  The more enduring aspect is likely to be higher levels of volatility, despite the extra liquidity that is being pumped in.

There are still lots of unresolved issues.  Perhaps the most important point is encapsulated in a 1950s German saying “Wer soll das bezhalen?” or who gets to pay for this?  After all, this is another transfer of risk into the hands of the public sector/governments/international agencies at a considerable long-term cost.  If the European Union/Eurozone can re-write its rule book in just a couple of hours, after dilly dallying like rabbits in front of the headlights for many months, a slightly higher level of absolute risk should priced into government bond yields.

Thursday last week saw an indecisive result for the UK General Election and on Sunday a decisive and negative result for the ruling German coalition in North Rhine-Westphalia.  There had already been a sharp correction in the UK equity market, which, from its peak on 15th April, fell 9.5% to midday Friday.  Meanwhile, sterling peaked on the same day, at least on an intermediate basis, and then fell just under 8% since then.  Over the same period, the Euro and sterling have fluctuated quite sharply against each other but are broadly unchanged.

History suggests that ‘hung’ parliaments in the UK are usually short-lived.  The February 1910 election resulted in a virtual tie between the Liberals, with 274 seats, and the Conservatives, with 272, though the latter secured 3% more of the votes cast.  The balance was held by Labour and Irish Nationalist members, with 111 seats between them.

Asquith, the Liberal leader, saw no reason to accept moral defeat, though his party had lost 123 seats.  He claimed there was a clear anti-Conservative majority.  All the same, his new Government proved unable to achieve its prime objective of House of Lords reform and, by November of that year, Asquith had called another election.

The 1920s was an era of three-party politics in the UK.  The December 1923 election produced a ‘hung’ result, with the Conservatives on 258, Labour on 191 and the Liberals with 158.  Baldwin, the Conservative prime minister, accepted that he had lost, seeing that the country had not demonstrated sufficient support of the policy of tariff reform on which he had run.  The Labour Government that then took office endured only until October 1924. At that election, the Conservatives came back with an overall majority of 209 seats.

The best-known ‘hung’ parliament was the one resulting from the 28 February 1974 election.  The balance of parties was then even more tenuous than the one emerging today, because the Liberals then had insufficient seats to provide a majority in combination with either of the other major parties.  The Conservatives had lost 37 seats but were still the largest party in terms of votes cast.  Their leader, Heath, felt entitled to try to form a government.   He spent four days after the election in this attempt, before resigning.

By 18 September 1974, the incoming Labour Prime Minister, Wilson, had called another election to take place on 10 October.  There had, by then, been sufficient movement in public opinion to give Labour an overall majority of 4 seats.

Clearly, a solid arrangement between the Conservative party and the Liberal Democratic Party might offer a longer-term prospect.  In the discussions over the weekend, the two parties appeared to be willing to agree on cutting UK public expenditure at least.  No doubt, the civil service briefing and the European background makes this an obvious area for agreement.

However, the Conservatives are unlikely to accede to the LibDems’ core demand for electoral reform.  The LibDems, meanwhile, would probably be unwise to put their faith in a Labour promise to push forward with electoral reform seeing that Labour and LibDems combined would not be in a position to command a parliamentary majority.   Maybe there will be a left leaning, ‘rainbow’ coalition.  The uncertainty is not helpful.

We believe that the UK Civil Service is well prepared for fiscal spending cuts and that an emergency budget is likely by the end of May or early June.  In a fiscal sense, the UK like more peripheral European countries is moving towards fiscal deflation.  The UK’s great advantage, though, compared with Greece, Portugal or Spain is that it controls its own currency.  The UK is able to devalue sterling.  Indeed, it has already done so.  By doing so it can use an external mechanism to adjust internal prices in overseas markets.  It does not have to adopt draconian domestic price cutting.

The risk associated with deep and swift cuts in public expenditure is obvious.  Such reductions are likely to produce an economic contraction and risk unleashing deflationary forces.  It also raises the spectre of a debt trap.  To be effective, deflationary fiscal policies need to be combined with stimulative monetary policies.   Maybe that is now the direction in which the European authorities intend to move.  This should be positive for asset prices.