In a new report with a quite bearish tone, the Italy-based investment advisory Mathema says that high correlations across asset classes and countries have dominated global markets in recent weeks.
A “post-election (Greece and France) scenario materialized” in May, the report says. The elections in both France and Greece gave market turbulence “the upper hand over risk appetite” and persuaded people to follow some old advice, “sell in May and go away.” The June philosophy thus far seems to be: Don’t buy in June, it’s way too soon.
Greece held a legislative election on May 6. Nobody could form a majority coalition out of the fragmentation of parties that resulted, and by the middle of the month a caretaker cabinet scheduled a new election for June. None of this inspired confidence.
Meanwhile, in France, François Hollande was elected President. Jean-Marc Ayrault became his prime minister. Though France is a core country in the eurozone and not part of the so-called periphery, this change in government, too, played into a high-volatility atmosphere.
Spain helped add gloom to the picture. On May 10, Spain took over one of its biggest banks, one that held 10% of the deposits within the Spanish banking system: Bankia SA. Bankia SA had come into existence only two years before, when the government tried to save weak smaller banks by herding them together into one.
By the end of May, the spread between German and Spanish bond yields was extraordinary. Spanish 10-year bonds were yielding 6.5%, German bonds only 1.347%. What Spain would have to do was becoming obvious to everyone by then, though it took Spain until well into June to do it, finally requesting and obtaining “from EU on June 10 a financial lifeline of up to 100 billion euro ($125B) to shore up its troubled banking system.”
There’s also a disturbing phenomenon that the report calls 'de-euroisation'. Euro area monetary financial institutions (MFIs) are holding fewer cross-border government bonds in relation to their total holdings. This ratio has been in decline since 2006.
Looking to the U.S.
Looking to the U.S., Mathema also urges caution. Unless something happens by the end of 2012, about 42 tax benefits expire. This will put pressure on the economy, adding to the deflationary impact of the excess unemployment. Indeed, Mathema pegs the “effective unemployment rate” in the U.S. as 14.5%, which is a sharp contrast with the official number of 8.1.
The U.S. government spends roughly $1.50 for every $1 in revenue. This is a circumstance comparable to spending during the Second World War, and “is unsustainable beyond the short term.”
As to the U.S. financials, Mathema says that “full details have yet to emerge about how JPMorgan Chase & Co. lost at least U.S. $2 billion from a failed hedging strategy.” The loss inspired Richard Fisher, president of the Dallas Federal Reserve, to ask about the adequacy of risk management at each of the country’s five largest banks.
CBOE volatility index increased more than 40% from the end of April to the end of May, although it is still well below the levels of last autumn.
A climb in the annualized ten-day rolling window volatility of the U.S. dollar swap spread at the end of May likely indicates “more negative expectations about the aggregated likelihood of default proceeding among market participants.”
Is China headed for a hard landing or a soft: That is the question. Mathema doesn’t put out an answer to that question, but it does tell us that China’s exports, expected to grow at an annualized rate of 8.5% in April, actually grew at a rate of just 4.9%. The country is “exposed to risks of a fresh downturn in demand for goods from its massive factory sector.”
Other Asian markets form some of the few bright spots Mathema can find. Foreign investors in Asian markets favored Japan, India, and South Korea over the 19 week period that ended on May 11, buying $18.51 billion of Japanese equities, $8.55 billion of Indian, and $8.33 billion of South Korean.
India’s finance ministry has shown a particular interest in attracting foreign investment, announcing in late May relaxation on the corporate bond holdings foreign retail investors can aggregate.
In September 2011, the Swiss National Bank faced risks of deflation and recession from the excessive strength of the Swiss currency against both the U.S. dollar and the euro. The CHF was a flight-to-quality asset. The SNB has intervened in the market to cap the value of its currency.
Switzerland saw strong growth in the first quarter 2012, and as Mathema says this “raises questions on the currency cap,” since it no longer seems necessary in order to avoid a recession. The country attracts skilled immigrants and its unemployment rate is only 3.1%.
In sum, Mathema cautions that assets classes are becoming increasingly correlated in a way that “zeroes out the benefit of diversification.”