The behavior of some asset classes have been downright puzzling. I have been writing for several weeks about what a basket case the eurozone is. Despite the results of the Greek vote on the weekend, nothing is solved. The contagion is starting to spread to Italy, as 10 year Italy-Bund spreads are blowing out.
The EFSF, whose details are still not finalized, is starting to look more and more DOA. Here is Lisa Pollock of FT Alphaville discussing how many investment banks won't even touch making a market on EFSF CDS:
With the EFSF though, it’s all about self-referencing, which is another way to describe the wrong-way risk involved.
To have a quick and dirty example of that, think about whether you’d buy protection on France from BNP Paribas, or protection on the UK from RBS, or protection on Germany from Deutsche Bank. If the CDS spreads on any of those banks started widening out significantly, it’s safe to bet that their lender-of-last-resort sovereigns will start widening too. This is something we’ve seen happen a lot over the last few years. Similarly, one can see banks widening with their sovereigns, as their backstops look increasingly vulnerable.
If you did any of those trades, you’d be deeper in-the-money, but at the same time, your counterparty is starting to look increasingly fragile (and you’re probably having to hedge against the possibility that they might not be able to pay you too).
A deteriorating outlook
What's more, the forward looking indicators are in decline even though the backward looking indicators are appeaing relatively buoyant. Both the Fed and the ECB cited deteriorating outlooks last week in their statements. Here's the ECB:
The economic outlook continues to be subject to particularly high uncertainty and intensified downside risks. Some of these risks have been materialising, which makes a significant downward revision to forecasts and projections for average real GDP growth in 2012 very likely.
And here's what the Fed said:
Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.
Ed Yardeni observed the same phenomena when he analyzed 3Q Earnings Season [emphasis added]:
It has been a great earnings season. It’s not over yet, but of the 388 S+P 500 companies that have reported their Q3 results, earnings are up 22.9% on a 12.7% increase in revenues. The problem is that even as companies have provided lots of positive surprises, analysts have been cutting their earnings estimates for Q4 and all four quarters of 2012. That’s because they are turning increasingly cautious on the outlook for revenues and for the profit margin.
The WSJ also echoed a similar sentiment when it wrote that Earnings Warnings Ratio Highest in a Decade.
Some excellent questions
If Europe is such a mess and the economic outlook is tanking, then why isn't the US Dollar, which is undervalued using PPP measures (see examples here and here) and the traditional safe haven, rallying harder? Shown below is the point and figure chart of the USD, why isn't it at least in an uptrend?
You could argue that investors are avoiding the USD because of fears of currency debasement, which is a serious problem with fiat currencies in the current environment. In that case, pressures should be showing up in hard asset prices. Why aren't commodities in a well-defined uptrend?
Those are, as they say, excellent questions.
Beware of policy intervention
Despite the overwhelming macro risks that face the market, I believe that the reasons that the price of risky assets haven't totally fallen apart is because Mr. Market is discounting the possibility of policy intervention. Last week, the FOMC statement had a decidedly dovish tone. While they did not outright announce QE3, they did say that the outlook is decidedly weak. More importantly, the two more hawkish members of the FOMC fell into line and voted with the rest of the Committee. The only dissenter was a dove who wanted greater accommodation. In the post-meeting press conference, Bernanke did allow that the Fed would look at MBS purchases if the circumstances were right.
On the next day, the ECB surprised the markets with a quarter point rate cut. Mario Draghi appeared to be far more pragmatic than Jean-Claude Trichet, though just as European. He did appease the German wing of the ECB by stating that sovereign debt purchases were intended to be "temporary" - which was very European of him.
Larry Jeddeloh of TIS Group is accordance with my views about market anticipation of central bank intervention [emphasis added]:
The ECB Moves and The Bernank Places a Put Under the Market—In the past forty eight hours, several important changes have taken place in the global central banking community. When new ECB chief Mario Draghi unexpectedly cut interest rates even by 1/4 point on Thursday, he confirmed what I have been saying about Europe’s economic position. Continental Europe is in recession and the models I look at suggest all of the major European economies will see rapid decelerations in their economies. This is one of the reasons why Draghi did what new central bankers seldom do, cut interest rates on virtually his first day at the job.
One day before Draghi moved the ECB into easing mode, the Bernank held a press conference after the FOMC meeting. For the first time in a long time, the stock market actually went up, rather than down after he finished. What did he say that the market liked? I think he was absolutely clear that the Fed will be there, if needed, should the economy decelerate. He set the stage for QE3 by reducing the Fed’s forecast for the economy and he gave little comfort on the employment front. He set up a move to QE3 solely on the basis of the Fed’s mandate...
There is more evidence the markets/CB policy have reached an inflection point. In the emerging countries, Brazil’s central bank has cut interest rates twice. India appears to have stopped tightening. China is beginning to make noises that their tightening cycle may be over. Japan is easing and intervening in their currency. If China begins to reflate and the Chinese equity market is behaving as if something is changing, then the outlook for Asia/commodities changes. My point here is the CBs are turning bullish on money creation. As a result, inflation is about to pick up, though with some lag.
That's why the markets aren't behaving worse and financial crisis safe havens like the US Dollar aren't behaving better. They are discounting the possibility of policy intervention, which would buoy the prices of risky assets such as commodities.
Still a tug-of-war
So where are we today? The markets continue to be dominated by tail-event headline risk. On one hand, it's fearful of the macro risks such as a eurozone banking crisis. If calamity strikes, it's a long way down from here. On the other hand, the possibility of central bank intervention lurks around the corner. In the meantime, the drip-drip-drip of news that we have avoided the firing squad one more day, e.g. Papandreou's vote of confidence, are prompting the rallies and provides an upward bias for equity markets.
I wrote in last week's post, Defying gravity, that my base case for the next few weeks remains a sideways market with a slight bullish bias and I continue to stick with that view:
While I recognize that the macro risks are enormous, but do you want to take the chance and step in front of a trillion or two of central bank stimulus?
Until the risks are resolved one way or the other, the markets are likely to be volatile, news-driven and range-bound.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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