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Is April the new May?

Apr. 19, 2011 12:59 PM ET
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Is April the new May? A well known saying among investors is “sell in May and go away”. In 2010 towards the end of April stock markets were moving along nicely following the selloff earlier in the year. Then towards the end of April stock markets suddenly started collapsing again due to the turmoil unleashed by the full blown Greek debt crisis. 2011, has almost mirrored 2010, the start of the year was generally very positive. Then there was the selloff as a result of the Japanese natural disaster and to a certain extent the turmoil in the Middle East and North Africa. Since the low of mid March 2011 stock markets have recovered nicely until in the last week when tensions in the Eurozone have re-emerged regarding a widely suspected need for Greece to enter a voluntary debt restructuring (the voluntary bit I feel is a little far-fetched with the pressure they are coming under by certain other Eurozone members!). Adding to all this was yesterday’s announcement by S&P putting the US on negative watch regarding its AAA credit rating. So what it looks like right now is we are in for a period of increased volatility and turbulence in financial markets in the short term. So to answer the above question is April the new May as regards selling equities........ Both 2010 and 2011 seem to be pointing to this!


In the past week markets are again being negatively affected by events within the Eurozone. The question is what can and needs to be done. Clearly the approach currently being taken by Eurozone political leaders is not helping the situation. In my view there is too much political meddling rather than economic focus to what is an economic problem. There are a number of solutions available from a full scale bailout to just letting certain countries default and restructure their debt and probably during that period of reconstruction temporarily leave the Eurozone. These are two extremes and therefore the answer does not lie at either end. There has got to be a solution that is both credible to markets and acceptable to Eurozone citizens.


The solution which I believe is the one that has the potential to work best is one which has already been mentioned by a number of commentators and politicians and that is the idea of the Euro Bond. The basic idea behind it is that a Eurozone debt agency would be set up to issue Euro debt on behalf of Eurozone governments. This I believe is a credible solution. Firstly, the debt agency would issue debt on behalf of governments based on a funding estimate of each government and to prevent governments from putting in ridiculously high funding estimates there would be a cap as to the amount any one country could apply for. If they wanted to run higher deficits they would need to issue their own national debt and would naturally pay a lot higher prices for it as the market would know they are living beyond their means. This change would allow the Eurozone to clean its act up. Breaking budget limits are not something new with the peripheral Eurozone debt crisis they have been with the Euro basically since its launch. Think back 7 or 8 years ago and recall how Germany and France for a sustained period broke EMU debt guidelines.  


This new Euro bond market would be a large liquid market. Following yesterday’s news of the US being put on negative watch by S&P makes a large liquid Euro government bond market an even more attractive proposition. The AAA USD government bond market is huge. It is well more than double the size of the current German Bund market. The issue now is if the US is downgraded and loses its AAA status where will investors go whose investment rules stipulate that must invest only in AAA debt securities? This has the potential to unleash great turmoil in the global bond markets. If we look at yesterday’s moves in the bond markets the major beneficiary of the news regarding the US credit outlook was the German government bond market. It significantly outperformed all other bond markets. However, if there is a downgrade of the US from AAA the German government bond market would probably not be able to cope with the flows of money trying to enter that market and would likely cause a very dangerous bubble.


The last point regarding a big Euro government bond market is the worry among some of the core Eurozone nations regarding the potential increase in borrowing costs. Yes, it is highly probable that borrowing costs would increase for this new market. However, this should be seen as something positive. Currently many investors who are looking for yield on their investments, particularly insurance companies and pension funds, just don’t get enough yield from government bonds. This is forcing them to invest in riskier assets at time when both the regulatory environment and their boards would rather they reduce risk. Therefore, a Euro government bond market which would offer higher yields than current markets would be attractive to such investors increasing demand for the new bonds. From 1990 to 1999 German 10 year yields averaged over 6% and from 1999 to 2011 the average was close to 4.5% therefore an increase in yields now would not be something unusual. It could also allow a window of opportunity for some Eurozone countries to restructure their debt obligations. Firstly a certain amount of their debt would be taken on by the new Euro government bond market up to a certain ceiling and then they would issue new national debt to cover their funding requirements above that.


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