Commentary: Should I Stay or Should I Go Now?
Last month I drew the distinction between risk and uncertainty and May delivered the shift in investors’ probabilities that finally turned the sizzle of Q1 to the fizzle of Q2. Global equities (MSCI ACWI total return in sterling) are down nearly 5% in May, and up just 1% so far this year. Emerging markets are off 8% in May, erasing all the exciting gains at the start of the year to stand 1% down so far in 2012. As one might expect the sectors suffering most – between 7% and 9% – across the globe this month have been Materials, Energy, and Financials. But the previous powerhouse of IT has also struggled, off over 5%.
Commodities have fallen sharply, and both oil and copper are off 10% or so. One crude indicator of risk is the Chicago Board’s VIX index, which rose dramatically in the first three weeks of May from 16 to 25 before easing to 21. The focus of global financial market uncertainty has once again been the trials and tribulations of the eurozone, specifically the political spasms in Greece as the election failed to produce a government and the struggle for capital and funding at a reasonable price is the clearest external sign of the strains playing out across Europe, where the ultimate tension may be felt again across the banking system.
Greece continues to be the media focus of the most extreme drama, with a fresh election on June 17th and opinion polls – banned for the two weeks prior to the ballot – currently suggesting the pro-austerity agreement parties are set for a coalition forming majority. However the real dangers to the eurozone lie beyond Greece, in Spain and Italy. The yield on Italian 10 year bonds rose to 5.8% (now 5.6%) and the yield on their Spanish equivalents reached 6.5% (now 6.3%).
The real fear for investors is not the direct cost of a Greek default, but the potential chaos that would ensue across the eurozone as a whole, and with their trading partners and creditor nations, like Britain. The consequences of a Greek exit would be brutal for the Greeks themselves, but if Portugal, Ireland, Spain and Italy were overwhelmed in the aftermath and the euro itself collapsed, then the Northern European members who have started muttering that they may be better off without Greece would find their super competitive export position eroded by a rapidly appreciating currency.
The problem facing the eurozone is not really an economic one. The Economist newspaper points out that aggregate eurozone debt is 87% of GDP compared with 100% in the United States. The yield on the 10 year US Treasury is 1.7%, while the yields on individual government’s debts across the eurozone vary from Germany’s enviable 1.4%, to Spain’s troubling 6.5% and Greece’s eye watering 26%.
The problem is political and structural. And therefore the solution must, ultimately, be political and structural, requiring firm, decisive and imaginative action. Not the kind of thing normally associated with politicians. No doubt they hope that time and President Hollande’s “growth” strategy will alleviate the crisis. It probably won’t. Ray Dalio of Bridgewater Associates opined in last week’s Barron’s that debt deleveraging usually takes fifteen years from a peak. Counting from 2007, time is not on Europe’s side.
A reminder of the pain of deleveraging came with Bankia’s troubles in Spain. The part-nationalised conglomeration of seven weak regional banks saw its shares hit by fears of deposit withdrawals. Two weeks ago it had €300bn in assets and received a €4.5bn injection of new capital. Last Friday Bankia asked for €19bn of additional capital and its shares were suspended. Here again is part of the eurozone’s structural problem.
Spain’s banks – like Ireland’s – lost hundreds of billions in loans secured on property that they will never recover. They just haven’t recognised it. If there was a central eurozone banking regulator or deposit guarantee scheme even these massive losses could be dealt with, as such losses have been in the United States.
My son’s history teacher once offered his pupils some rules to live by. Along with “never start a land war in Asia”, “never go back, to a girlfriend, holiday destination or a firework” and “never trust the French”, was one that came back to me in the light of JP Morgan’s likely $2 billion credit derivative trading loss. “Never”, Mr Floyd said, “play cards with anyone who’s middle name is ‘the’”. Would JP Morgan’s shareholders be reflecting on a $30bn drop in market value if their London trading arm wasn’t run by someone apparently called “the London Whale” and “Lord Voldemort.”
Although the post-Lehman world was supposed to see a return to the dull as ditchwater banking with capital conserved and asset growth pursued sensibly for modest but stable returns. This behavioural change clearly hasn’t quite taken place but at least the loss has been recognised and discounted in the share price.
Volatility rules at the moment in financial markets and there is no clear direction. The United States has been the equity market to be in for a sterling based investor, down just 2% compared with the world down nearly 5%. Economic data continues to be reasonable and the outlook is for positive but modest growth, say 2-2.5%, below the long run trend but still solid in a global context. It is also clear that if there’s a disappointment the Fed will return to quantitative easing.
The picture is cloudier towards the year end – no impetus for policy action as the election nears – and in 2013 the fiscal cliff will have to be faced. But the United States has made slow but steady progress with unemployment and domestic activity, and will have to address the public finances in due course. At least they possess the mechanisms for doing so, unlike Europe.
This coming week will see fresh data on US payrolls and unemployment.
The export orientated Asian economies – and the commodity based emerging economies – have suffered significantly in the past two months. Partly this reflects their greater sensitivity to perceived market risk, and partly a reaction to concerns over slowing Chinese growth.
In the absence of a further “shock” on the eurozone road to nowhere risk assets seem oversold short term and ripe for a bounce, continuing the noisy journey to a dull destination.
Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton