A case for market intervention?
As we wait for ECB Mario Draghi to come good on his promise to do all in his power to save the euro, the case for governments intervening in financial markets is once again to the fore. Draghi’s verbal intervention last week basically opened up a number of fronts. First, he clearly identified the extreme government bond spreads within the euro zone, where Germany and almost half a dozen euro countries can borrow for next to nothing while Spain and Italy pay 4-7%, as making a mockery of a single monetary policy and that they screwed up the ECB’s monetary policy transmission mechanism. And second, to the extent that the euro risks collapse if these spreads persist or widen further, Draghi then stated it’s the ECB’s job to do all it can to close those spreads. No euro = no ECB. It’s existential, in other words. The ECB can hardly be pursuing “price stability” within the euro zone by allowing the single currency to blow up.
Whatever Draghi does about this, however, it’s clear the central bank has set itself up for a long battle to effectively target narrower peripheral euro bond spreads — even if it stops short of an absolute cap. Is that justified if market brokers do not close these gaps of their own accord? Or should governments and central banks just blithely accept market pricing as a given even if they doubt their accuracy? Many will argue that if countries are sticking to promised budgetary programmes, then there is reason to support that by capping borrowing rates. Budget cuts alone will not bring down debts if borrowing rates remain this high because both depress the other key variable of economic growth.
But, as Belgian economist Paul de Grauwe argued earlier this year, how can we be sure that the “market” is pricing government debt for Spain and Italy now at around 7% any more accurately than it was when it was happily lending to Greece, Ireland and Portugal for 10 years at ludicrous rates about 3% back in 2005 before the crisis? Most now accept that those sorts of lending rates were nonsensical. Are 7%+ yields just as random? Should governments and the public that accepts the pre-credit crisis lending as grossly excessive now be just as sceptical in a symmetrical world? And should the authorities be as justified in acting to limit those high rates now as much as they should clearly have done something to prevent the unjustifiably low rates that blew the credit bubble everywhere — not just in the euro zone? De Grauwe wrote:
Economists now agree that markets were wrong in placing the same risk premium on Greek bonds as on German bonds….the same markets are also wrong in overestimating the risk that the periphery countries will default. Policymakers looking to calm such skittish markets should take note.
You may well argue that if no one wants to lend, then no one wants to lend. But call up most fund managers or potential long-term creditors right now and they will tell you that they will buy Italy and Spain, when policy credibility is blessed by the “market” and rates are already falling. Hmmm. So, who’s setting these prices then? Oxford economist Simon Wren-Lewis in April made his entertaining thoughts on the danger of pandering to notional “vengeful god” of the financial market quite clear.
To treat financial markets or the economy as a whole as always behaving like a vengeful god whose mood and confidence can ebb and flow at the slightest provocation is not the way to make good policy.
In a world where the failures of unfettered financial markets are all too apparent after 10-years of extraordinary excesses and withering busts, the consensus is that greater regulation of banking and trading is necessary and the taxpayers and their government agents that are footing the bill for these ructions should have more of a say. The only thing odd then would appear to be why it’s taken Draghi and co so long. Let’s see what he comes up with today.
Will Poland have an “ECB moment”?
When Poland stunned markets in May with a quarter-point rate rise, analysts at Capital Economics predicted that the central bank would have an “ECB moment” before the year was over, a reference to the European Central Bank’s decision to cut interest rates last year, just months after it hiked them. A slew of weak economic data, from industrial output to retail sales and employment, indicates the ECB moment could arrive sooner than expected. PMI readings today shows the manufacturing business climate deteriorated for the fourth straight month, remaining in contraction territory.
With central banks all around intent on cutting rates, markets, unsurprisingly, are betting on easing in Poland as well. A 25 bps cut is priced for September and 75 bps for the next 12 months, encouraged by dovish comments from a couple of board members (one of whom had backed May’s decision to raise rates). Bond yields have fallen by 60-80 basis points.
Marcin Mrowiec, chief economist at Bank Pekao says:
The market should continue to expect that the (central bank) will unwind the rate hike delivered in May.
There are two hurdles. One is inflation. Price growth is running at 4.3 percent, well above the 2.5 percent target set by the inflation-targeting central bank. That was what triggered the May rate rise.
Second, in Poland, as in Hungary, the central bank cannot afford to let the currency weaken much. A third of government and corporate debt is hard currency, while half of all mortgages are in Swiss francs. A fall in the zloty, caused by a rate cut, could raise defaults and problems for the banks. (See here for a story on Poland’s Swiss franc loan problem).
But with exports to the recession-hit euro economy providing a fifth of Poland’s GDP, Capital Economics reckon a rate cut is inevitable.
Running for gold? The long-distance investor
What are you best at? Running a sprint? Jumping a few hurdles? Or would you rather gear up for the long-haul with a marathon?
With the London 2012 Olympics in full speed UK investors are going for the long-distance rather than try to follow in Usain Bolt’s speed-lightning sprints, a poll by Barclays Stockbrokers showed.
Thirty-one percent of surveyed clients liken their investment strategy to a marathon ( “investing for the long term” ) and 34 percent to an heptathlon (“long term investment strategy which requires several different approaches.”)
Only 9 percent go for the 100 meter sprint (“spot investments opportunities and react with speed”) and 10 percent choose pole vault’s high-risk investment approach, while 16 percent are simply focused on clearing hurdles one at a time, the survey of 719 clients showed.
In a separate poll, answered by 468 of its clients, Barclays Stockbrokers asked: Thinking about the Olympics, which countries / regions have offered you the best investment returns?
- UK (London 2012) 56%
- China (Beijing 2008) 16%
- Europe (Athens 2004) 4%
- Australia (Sydney 2000) 9%
- US (Atlanta 1998) 14%
So maybe home advantage is the best approach after all?
Devil and the deep blue sea
Ok, it’s a big policy week and of course it could either way for markets. An awful lot of ECB and Fed easing expectations may well be in the price already, so some delivery would appear to be important especially now that ECB chief Mario Draghi has set everyone up for fireworks in Frankfurt.
But if it’s even possible to look beyond the meetings for a moment, it’s interesting to see how the other forces are stacked up.
Perhaps the least obvious market statistic as July draws to a close is that, with gains of more than 10 percent, Wall St equities have so far had their best year-to-date since 2003. Who would have thunk it in a summer of market doom and despair. Now that could be a blessing or a curse for those trying to parse the remainder of the year. Gloomy chartists and uber-bears such as SocGen’s Albert Edwards warn variously of either hyper-negative chart signals on the S&P500, such as the “Ultimate Death Cross”, or claims that the U.S. has already entered recession in the third quarter.
On the other hand, the economic data isn’t playing ball with doomsters, as can be seen in Thursday’s latest U.S. consumer and business confidence readings as well as the latest house price data. What’s more, the closely watched Citigroup Economic Surprise index, though still in negative territory, is turning higher again as a result amid some hopes for at least a midyear fillip in manufacturing worldwide. Of course surprises are only relative to expectations. But then sufficiently lowered expectations are no bad thing in a marketplace attempting to discount all available information. It’s true too of the ongoing U.S. earnings season, where there had been a sharp downgrade of forecasts in the weeks leading up the corporate reports. Thomson Reuters data shows that of the 303 firms in the S&P500 who have already reported Q2 earnings, some 66 percent are above analysts expectations — just shy of the average of of the past four quarters of 68 percent.
There is the hoary old argument that lukewarm economic signals will prevent the Fed from moving soon again on QE3, in part because the bar may be higher in an election year. But that just throws us back to the policy arena yet again and we promised to step aside from that for now!
The final piece of the puzzle is looking at alternatives to still apparently well-valued U.S. equities. With top-rated government bonds around the world the destination of choice for several quarters now, the yield implications have indeed been dramatic. Not only are up to half a dozen core euro zone Treasury bill yields now prefaced by a minus sign, even two-year German bonds now offer only negative yields. U.S. bill rates, meantime, have dipped again to their lowest levels since the 19th century, while 10-year German and U.S. Treasury bonds yields are less than 1.5 percent. At these rates, a backup in yields of less than 20 basis points could wipe out returns for the year. The risk in these markets is rising too despite their perception as havens.
Yet, that’s where global investors are getting sucked in. Today’s release of the Reuters Asset Allocation Poll for July showed the aggregate positions of some 49 investment funds worldwide showed global bond holdings at their highest since at least January 2010, with government bonds favoured over corporate credit.
Power failures shine light on India’s woes
Half of India’s 1.2 billion people have been without power today, bringing transport, factories and offices to a grinding halt for the second day in a row and sparking rage amongst the sweltering population. That’s embarrassing enough for a country that prides itself as a member of the BRIC quartet of big emerging powerhouses along with Brazil, Russia and China. But the outages will also hit economic growth which is already at 10-year lows. And the power failures, highlighting India’s woeful infrastructure, bode poorly for the government’s plans to step up manufacturing and lure more foreign companies to the factory sector.
India urgently needs to increase production and exports of manufactured goods. After all, software or pharma exports do not create jobs for a huge and largely unskilled population. India should be making and selling toys, clothes, shoes –- the things that helped lift hundreds of millions of Chinese, Taiwanese and Koreans out of poverty and fuelled the current account surpluses in these countries. At present, manufacturing provides less than 16 percent of India’s gross domestic product (30 percent in China, 25 percent in South Korea and Taiwan) but the government wants to raise that to 26 percent by 2022. Trade minister Anand Sharma, in London last week, for a pre-Olympics conference, was eloquent on the plan to boost manufacturing exports to plug the current account gap:
In coming decades, India will be transformed into a major manufacturing hub of the world.
Unfortunately, without better infrastructure — roads, electricity and ports — that will remain a pipe dream. Above all, factories need power. (Most workshops in India must resort to costly back-up power supplied by diesel generators) While India has indeed pencilled in a $1 trillion investment target to revive infrastructure, half the funding is to come from the private sector and a flagging world economy could scupper those plans.
One hope remains — that this week’s embarrassment galvanises the government into some bold reform moves. As Jeff Glekin, my Mumbai-based colleague from Breaking Views writes:
What the country needs most is improvements in chronically mismanaged infrastructure. Change is hard when systems are working, even badly. So a huge power outage…could prove a blessing.
India, a hawk among central bank doves
So India has not joined emerging central banks’ rate-cutting spree . After recent rate cuts in Brazil, South Korea, South Africa, Philippines and Colombia, and others signalling their worries over the state of economic growth, hawks are in short supply among the world’s increasingly dovish central banks. But the Reserve Bank of India is one.
With GDP growth slowing to 10-year lows, the RBI would dearly love to follow other central banks in cutting rates. But its pointed warning on inflation on the eve of today’s policy meeting practically sealed the meeting’s outcome. Interest rates have duly been kept on hold, though in a nod to the tough conditions, the RBI did ease banks’ statutory liquidity ratio. The move will free up some more cash for lending.
What is more significant is that the RBI has revised up its inflation forecast for the coming year by half a percentage point, and in a post-meeting statement said rate cuts at this stage would do little to boost flagging growth. That, to many analysts, is a signal the bank will provide little monetary accommodation in coming months. and may force markets to pedal back on their expectation of 100 basis points of rate cuts in the next 12 months. Anubhuti Sahay at Standard Chartered in Mumbai says:
On economic growth, though the moderation has been noted, the RBI sees limited role of rate cuts in stimulating growth. Overall, it affirms our view that any rate cut from the RBI is unlikely in the rest of 2012.
Elsewhere in emerging markets too, no rate cuts are expected this week, with Czech and Romanian central banks likely staying on hold when they meet on Thursday.
Czech rates were cut in June to record lows but analysts reckon that fear of further currency weakness, especially against the dollar will prevent the central bank from cutting rates any further this year. In Romania, a raging political storm and doubts over the fate of an IMF loan deal has pushed the leu currency to record lows meaning the central bank has little room at the moment to move interest rates lower.
Mrs Watanabe in Istanbul
Japanese mom-and-pop investors’ penchant for seeking high-yield investments overseas is well known. Mrs Watanabe (as the canny player of currency and exchange rate arbitrage has come to be known) invests billions of yen overseas every year via so-called uridashi bonds, debt denominated in currencies with high yields. Data shows the lira has suddenly become the red-hot favourite with uridashi investors this year.
In a note entitled Welcome Mrs Watanabe, Barclays analysts estimate $2 billion in lira-based uridashi issuance this year, ahead of old favourite, the Australian dollar.
So far, Japan’s exposure to Turkey is negligible at just 1.2 percent of their emerging market portfolio investments (Brazil is 4 percent, Korea 3 percent and Mexico 2 percent). But Turkey’s high yields (almost 8 percent on one-year bonds) and the lira’s resilience mean the figure could rise to $5-$6 billion a year. That is almost half of total portfolio flows to Turkey in 2011, Barclays says.
Its analysts note that Brazil has fallen from favour with Mrs Watanabe as the central bank there has cut rates sharply, taxed foreign inflows and pushed the real down almost 10 percent to the dollar. In contrast, the Turkish lira is up 5 percent this year. The central bank has signalled it will not countenance a weaker lira and kept monetary policy tight. It has also not stood in the way of flows to local bond markets which have received almost $8 billion this year from foreigners. Barclays write:
Turkey and some other high-yielding EM countries such as Russia may find themselves beneficiaries of investor interest previously directed at Brazil and the real….If Turkey succeeds in attracting more and more of these flows, the lira exchange rate is likely to benefit, as well as the Turkish bond market where these flows could end up.
- additional reporting by Nevzat Devranoglu
Emerging market debt with silver pedigree
Guarantees on emerging market debt need to be silver-plated these days after the defaults of Ukraine’s state energy firm Naftogaz and Kazakhstan’s BTA bank in recent years show implied guarantees are not worth the paper that they weren’t even written on.
Tunisia must have taken that to heart as it issued a dollar bond this month guaranteed by the United States, still rated AAA by two major ratings agencies.
Tunisia was planning to launch a Eurobond before the Arab Spring uprisings last year, but the bond was shelved and investors remain cautious about the country’s economic outlook. The country’s central bank governor was sacked a few weeks ago and its finance minister quit last week.
The U.S.-guaranteed bond had a coupon of 1.686 percent, compared with yields on Tunisian debt of around 6 percent, and was the lowest coupon on any bond issued by the country, according to Natixis, one of the lead managers of the bond.
The $485 million bond was oversubscribed and attracted investors from outside the usual emerging market universe, according to Nabil Menai, global head of emerging market debt origination at Natixis:
We had 3-4 pension funds who can only invest in AAA, you will never see them on an emerging market bond.
The bond offered a pick-up over U.S Treasuries of 70 basis points, appealing to investors in a developed world of increasingly negative returns.
GUEST BLOG: The missing reform in the Kay Review
Simon Wong is partner at investment firm Governance for Owners, adjunct professor of law at Northwestern University School of Law, and visiting fellow at the London School of Economics. He can be found on Twitter at @SimonCYWong. The opinions expressed reflect his personal views only.
There is much to commend in the Kay Review final report. It contains a rigorous analysis of the causes of short-termism in the UK equity markets and wide-ranging, thoughtful recommendations on the way forward. Yet, it is surprising that John Kay omitted one crucial reform that would materially affect of the achievability of several of his key recommendations – shortening the chain of intermediaries, eliminating the use of short-term performance metrics for asset managers, and adopting more concentrated portfolios. What’s missing? Reconfiguring the structure and governance of pension funds.
A major challenge facing pension funds in the UK and elsewhere is the lack of relevant expertise and knowledge at board and management levels. Consequently, many rely heavily – some would argue excessively – on external advisers. I have been told by one UK pensions expert that inadequate knowledge and skills within retirement funds means that investment consultants are effectively running most small- to medium-sized pension schemes in Britain. Another admits that trustees, many of whom are ordinary lay people with limited investment experience, are often intimidated by asset managers.
Because these funds cannot afford to build in-house investment capabilities, they outsource this function to external managers. What’s more, some pension funds will utilize intermediary “funds of funds” to help them make investment decisions, thereby extending the equity ownership chain.
Strengthening board and management capabilities at pension funds would bring substantial benefits to their schemes and the broader economy. First, trustees and executives would be better equipped to make investment and other key decisions on their own, including questioning prevailing practices that may benefit investment intermediaries more than them. For example, they could challenge their investment consultants and fund managers on why adequate diversification requires holding 8,000-10,000 stocks rather than a more manageable 3,000-4,000 (or an even smaller number).
Second, they would be more capable of assessing investment manager performance rigorously and thoroughly. Presently, reflecting their trustees’ paucity of expertise on investment matters, many pension funds employ crude performance metrics (e.g., quarterly return against a pre-selected market benchmark) to evaluate fund managers.
I agree Simon. The very good thing about the Kay Review is that it puts a nail in the coffin of the debate about short-termism. You really have to intend to be a part of the problem if you continue to say “but is there really evidence of a problem” or “do investors really contribute to it”!
I also agree that this is one of the important missing dimensions. There is good corroborating evidence for your argument from a senior exec from Mercers who has compared the effectiveness of pension schemes in different countries. Australian, Netherlands and Canada come out ahead of UK & USA.
http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=2061680
This leads to the question who would suffer if the UK did what has been done by e.g. the Australians and “too small to be safe” funds were merged? Some players will object to change because it means a contraction of income and being held to higher standards. Others may still be amendable to taking action even though Kay didn’t mention it. The trade unions SHOULD be one such group. A lot depends on how seriously they take their stated mission, to look after their members’ best interests and how willing they are to challenge immunity to change in their own ranks.
Emerging debt default rates on the rise
Times are tough and unsurprisingly, default rates among emerging market companies are rising.
David Spegel, ING Bank’s head of emerging debt, has a note out, calculating that there have been $8.271 billion worth of defaults by 19 emerging market issuers so far this year — nearly double the total $4.28 billion witnessed during the whole of 2011.
And there is more to come — 208 bonds worth $75.7 billion are currently trading at yield levels classed as distressed (above 1000 basis points), Spegel says, while another 120 bonds worth $45 billion are at “stressed” levels (yields between 700 and 999 bps). Over half of the “distressed” bonds are in Latin America (see graphic below). His list suggests there could be $2.4 billion worth of additional defaults in 2012 which would bring the 2012 total to $10.7 billion. Spegel adds however that defaults would drop next year to $6.8 billion.
Now for the good news. These default rates, seen peaking in November at 3.6 percent, are actually pretty low (Emerging market defaults rose to 13.75 percent in December 2009 and were at a record high 30 percent during the 2001-2002 crisis) and Spegel estimates that the worst is now past. Second, default rates in EM are neck and neck with U.S. speculative grade corporates and should have the edge by year-end, according to ING. The note says:
Emerging markets’ higher yields, despite comparable default rates, should help entice further flows from developed markets….Emerging corporate spreads remain significantly more alluring than those in the United States even in the high-grade arena.
